Probably most of the most persistent and wide spread views of the general public is that a large currency devaluation results in more or less equivalent losses in purchasing power. Thus an exit of a periphery country from the Euro (which would probably be accompanied by a large devaluation of between 20-50%) is not considered a viable alternative to the current real income losses due to austerity and recession.

Unfortunately, the reality is quite different. Large devaluations are accompanied with significant changes in the CPI-based Real Exchange Rate (while if the loss of purchasing power was equal to the devaluation, the RER would not move). This is due to the fact that a devaluation only changes the import/export prices of tradable goods, not the general price level.

A very interesting study on the subject suggests a simple accounting model of calculating the effects of a devaluation on the CPI. It starts with a simple index where all goods are considered tradable and changes it to reflect reality:

Table 1 shows that there is substantial comovement between the price of imports and exports and the nominal exchange rate. In Argentina, Brazil, and Mexico this comovement is present at all the horizons we consider. For Korea and Thailand, the comovement is stronger in the first few months after the devaluation

Table 1 indicates that the retail price of tradable goods moves by much less than the price of imports and exports (see also Figure 1).Table 1 also shows that the price of nontradable goods and services moves by much less than the rate of devaluation. Although the retail prices of tradable goods move more than prices of nontradable goods and services, the differences are small relative to overall movements in the nominal exchange rate.

According to Table 3 on average, nontradable goods account for roughly 50 percent of the CPI basket. In our view, this decomposition substantially understates the percentage of the CPI basket that is composed of nontradables because it ignores distribution costs for tradable goods and local goods.
Recall that we compute the CPI using retail prices. These prices are necessarily different from producer prices, because they reflect distribution costs associated with wholesale and retail services, marketing and advertising, and local transportation services. Burstein, Neves, and Rebelo (2003) show that these costs are large. According to their estimates, the average distribution margin for consumption goods, is roughly 50 percent.

Distribution services are nontradable in nature, since they are intensive in local land and labor. So Burstein, Neves, and Rebelo’s findings imply that half of the retail price of a tradable good reflects nontradable goods and services. Consequently, distribution costs account for approximately 25 percent of the CPI bundle raising the total share of nontradables in the CPI to 75 percent.

Consider the remaining 25 percent of the CPI basket classfified as tradable goods. Many of these goods are actually local goods that are produced solely for domestic consumption. For example, yogurt is traditionally classiffied as a tradable good. However, almost all the yogurt produced in Argentina is sold locally (see Table 8, which provides additional examples). It is difficult to precisely estimate the share of local goods in the CPI. However, the calculations below suggest that local goods could represent as much as 22 percent of tradable goods or 11 percent of consumption. In this case, taking distribution costs and local goods into account reduces the share of pure-traded goods in the CPI basket to 14 percent.

price accounting for large devaluationsIt is clear that although initial devaluations are significant (128% in the case of Argentina), the final result on the CPI is much lower (34%):

annual prices deflators in large devaluations

Another, more detailed approach, is the one taken by another paper, which uses Input-Output tables to compute the results of a 50% drachma devaluation (after a switch from the Euro to national currency) on the CPI, under various model assumptions (such as whether workers try to avoid losses in purchasing power by demanding higher wages). The conclusion is that, under the most ‘inflation-prone’ model, the first year inflation will be 9.3%, a rather small cost for the return of sovereignty.

per-period cost inflation ratesAnother way to gain more perspective on the subject is to look into the recent high inflation history of Greece during the 80’s, early 90’s. The Ameco database provides a very useful statistical series with the contributions of various factors to the final demand deflator. The factors are import prices (corrected for the exchange rate), the exchange rate, nominal ULC, gross-operating surplus (firm profit margins) and net indirect taxes. The series can be used as a close proxy for the CPI and allows one to breakdown inflation into the contributions of the domestic sector and the exchange rate:

Greece - Contributions of Domestic and Exchange rate sector to final demand deflator

During the 80’s the mean contributions of the exchange rate and the domestic sector were 3.3% and 15.4% while in the 90’s 1% and 8.9%. Neither the inflation of the 80’s, nor the disinflation of the 90’s was a result of the external sector (constant depreciation in the first period, ‘strong drachma policy’ in the second) but of large (monetary) claims of the domestic sector on production. Inflation dropped because the domestic sector contribution went from 15% in 1990-1991 to 5% in 1997 and 2.5% in 2000 (the same values for the exchange rate were 2%, and -0.5%). One can attribute the persistent high inflation to mismanagement and loose monetary policy rather than to currency depreciation.