Devaluation and the Real Exchange Rate
By Arnold Kling
If the Drachma goes from 1:1 Euros to 2:1 Euros and Greek prices and wages double, nothing happens. On the other hand, if prices and wages don’t change, then Greek goods are cheaper and Greece will produce and export more.
If domestic wages and prices do not change by the full amount of a currency devaluation, the real exchange rate depreciates and net exports should increase. That seems true enough. Cochrane then argues that an anticipated devaluation is more likely to be accompanied by wage and price increases. That is standard macroeconomic thinking of the rational-expectations sort. I have never cared for it.
It seems to me that if the rational-expectations theory held, then Greece would not be in its current pickle. Wages and prices there would have fallen in order to make its tradable sectors more competitive.
One way to frame my disagreement is that given a choice between rational-expectations macro and old-fashioned Keynesian macro, I am afraid that I pick the latter.