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Bulletin of Indonesian EconomicStudiesPublication details, including instructions for authors and subscription information:http://www.informaworld.com/smpp/title~content=t713406865

Exchange Rate Protection in IndonesiaPeter G. Warr aa Australian National University,

Online Publication Date: 01 August 1984To cite this Article: Warr, Peter G. (1984) 'Exchange Rate Protection in Indonesia ',Bulletin of Indonesian Economic Studies, 20:2, 53 - 89To link to this article: DOI: 10.1080/00074918412331334612URL: http://dx.doi.org/10.1080/00074918412331334612

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Bulletin of I ndanes m Economic Studies Vol XX No 2. August 1984

EXCHANGE RATE PROTECTION ININDONESIA*Peter 0 .W ar r

Ausirdran ?Volional Universily

INTRODUCTIONA government pursuing a f ixed exchange rate policy, or a closeapproximation to i t , may a djust i ts exchange rate for any of severalreasons. Balance of payments concerns are obviously the mostim po rtan t , but other motivations can also play a role. A significantexample is the desire to use exchange rate adjustments to favoursome sectors of the economy relative to others. Devaluations areoften used in an effor t to favour those sectors of the domesticeconomy producing internationally traded goods or close substi-tute s for them relat ive to those sectors producing no n-traded goodsand services.

Th e term 'exchange rate p rotection' has recently come to be usedto descr ibe devaluations which are und er taken for this reason andalso to descr ibe th e avoidance of revaluations which would other-wise have occurred. ' Exchange ra te protection implies the accumu -lat ion of foreign exchange reserves at a rate greater than the ratedesired on purely monetary grou nds. V ery f requen tly, both balanceof payments and exchange rate protect ion considerat ions play arole in the policy discussions preceding devaluations, but theirrelative importance varies considerably.Indonesia 's two recent and large devaluations, of November1978 and March 1983, appear to have di f fered in the relative

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importance of these two motivations. Protectionist motives seemt o have played a role in bo th, bu t their im po rtance would a ppe ar tohave been greater in the case of th e 1978 devaluation. The 1978deva luat ion provides a relatively clear example of a devaluationmotivated primarily by protectionist considerations. By late 1978the contract ionary effects of the oi l pr ice boom on the nou-oi lt raded goods-producing sectors of the Indonesian economy werevery ap pa ren t. Th e profi tab il i ty of impo rt-competing sectors inparticular had declined significantly. In such cases, it is commonfor governments to be asked to grant addi t ional tar i ff and/orim po rt qu ota protection to these industries, but in Indonesia thereare complicating factors.Indonesias import-competing m anu factu ring sectors are alreadyhighly protected (Pitt 1981; Boediono 1983). Moreover, smugglingis widespread and this implies that further increases in tariffs, ortightening of quota restrictions, will he likely to have only mutedeffects on the domestic prices of these commodities. Tightening ofprotective barriers increases the attractiveness of smuggling andthis smuggling response dilutes the degree to which protectionistpolicies have the desired effe cts of raising the dom estic prices of th etarget commodities. Raising conventional protective barriers alsoleads to in terna tiona l cri ticism, an d som etimes to retaliation fro mtrading partners. In such circumstances, the use of exchange rateadju stm ents in an eff ort to raise the dom estic profitabil ity of theseindustries has obvious political attraction.Indonesias freely convertible currency means that everyone,smugglers included, must convert domestic currency into foreignexchange at th e official exchange rate. T o the extent that exchangerate protection has the effect of raising the domestic prices oftraded go od s relative t o non -trade d g ood s, then , this device may becapable of achieving some degree of protection of the non-oil

zOn November 15, 1978, the exchange rate was devalued fro m R p 415/SUS, atwhich value it had been pegged since A u g w t 1971, lo R p 625/SUS. This rate ofdevaluation was 50% when measured in terms of the home currency and 33.3%when measured in terms of the dollar value of the rupiah. Th e rate was subsequentlyallowed to float d ow nw ards gradually until M arch 30, 1983, when it was officiallydevalued fro m Rp 700/$US t o Rp 9?O/SUS.T h is is made clear in the 1Y?8/7Y Annuol Report of Bank Indonesia (especiallyp. xi) and in the public statements referred to in the coverage of the For EarrernEconomic Review, December I, 1978. A subsequent article by Professor J.E.Ismael, the Director of Bank Indonesia (Ismael 1980, p. 103) States that th e devalu a-tion %as carried out with a view 10 improve Indonesias international competitiveposition and thus stimulating the development of export and import substirutionindustries which had been und er increasing cost pressures due to a faster rate ofinflation in Indonesia in th e reeent yeacs than the rate abro ad.

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traded goods-producing sectors o f the economy that would n ot bepossible through other m eans.In late 1978 the view was widely held that the non-oil tradedgo ods -pro duc ing sectors of Indonesias economy s hou ld beshielded from the general equilibrium effects of the oil boo m . Th esup po rt fo r this policy objective derived from m or e than simply thesectional interests of pro du cer s in those indu stries. It also reflectedthe generally held presumption that Indonesias oil exports wouldinevitably decline in volume terms within the forseeable future,possibly vanishing entirely within twenty years. This presumption

was based o n extrapo lations of recent trends in Indonesias pro duc -t ion and domest ic consumption of petroleum and petroleum pro-ducts. Production showed negligible growth while consumptionwas expanding at 10 t o 12 per cent per annum.If the oil exports were to run out so quickly, i t was contended,then it was b oth economically wasteful an d polit ically dan gero us toallow the non-oil trade d go ods sectors to contract in the sh ort runonly to be required to expand again a decade or two later. In addi -tion, it was widely agreed that the rate at which Indonesias oilrevenues could productively be utilised within the domesticeconomy was limited and that short ru n accu mu lat ion of foreignexchange reserves w as desirable. A ccording to this arg um en t, theseresources would ultim ately be utilised m o re efficiently if the ra te ofabsorpt ion into the domest ic economy was slowed, and this t imephasing could be facilitated by tem po ra ry exchange rate protection.Th e term exchange rate protection is easily m isun ders tood andi t is imp or tan t to realise th at th e effects o f using th e exchange ratefor protective purposes differ from the effects of the conventionalinstruments of commercial policy - ncluding tar i ffs and importquo tas - n several important respects. First, they differ in theirre la tionship t o smuggling, as described a b ~ v e . ~econd, unliketariffs and import quotas, which affect the domestic prices oftraded commodities relative to one another, exchange rate protec-t ion aims t o influence th e domestic prices of trad ed comm odities asa group relative to non-traded commodities. Its impact is conse-qu en tly mu ch less specific. If the aim is to protect particular t radedgo od industries, exchange rate m anip ulation is a very cru de instru-ment .

We shall show later that in the case of commodities where import quotas wereeffective in restraining imports, devaluation would be ineffective as a protectivedevice. The protective efficacy of devaluation in the case of quota-restricted com-modities rests on the failure of quantitative mtrictions to achieve their intendedeffects.


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A thir d difference is th at w hile the relative price effects of tar iff sand impor t quotas a re permanent , those of exchange rate protec-tion a re likely to be te m por ary. Th is is a crucial point an d we shallreview the reasons for it below. Finally, we should note that in acou ntry like Indon esia , where a high pr op ort io n of exp ort revenueaccrues directly to the gw er n m en t in the for m of petroleum taxes,exchange rate adjustments have major (but temporary) implica-tions f o r the real value of governm ent revenue. Dev aluations raiserevenue, but this effect persists only as long as the relative priceeffects persist.

In the following section of this paper we briefly review thetheoretical basis for the presumption that Indonesias petroleumexport boom would cause the non-oi l t raded goods sectors todecline, and also the likely o utco m e of a t tem pts t o a m eliorate theseeffects through exchange rate protection. It is concluded that onlyshort-run amelioration would be likely. The next section discussesthe empirical experience from othe r countries on the effects ofdevaluations on relative dom estic prices. This also leads to the con-clusion tha t the effects are tem po rar y, generally having largely dis-appeared within roughly three years. Finally, we examine the em-pirical evidence on the relative price effects of Indonesias 1978devaluation. This suggests that the relative price effects reached apeak after four to f ive months, af ter which they were gradual lyeroded. This erosion is likened to a process of radioactive decaywith a half-life of approximately a further two years.THEORETlCAL BACKGROUND: THE DUTCH DISEASE ANDEXCHANGE RATE PROTECTIONT he theoretical p resum ption that ab sorpt ion of the revenues fromIndonesias petroleum boom would be to the disadvantage of In-donesias non-oil traded goods sectors is illustrated in Figure 1 .Pro duc tion possibili ties befo re the petroleum bo om are depicted bythe schedule N T . It is assumed for convenience that domesticdemand conditions can be represented by the social indifferencecurves U,, U , an d U,. The initial equilibrium is at point A . T he

See Gray (1982) for a useful discussion of this issue. Gray does not make thepoint that the effects of a devaluation on the real value of the [ax revenues areeroded and finally disappear as the traded/non-traded good price ratio returns to itspre-devaluation value.T h i s section draws in part on Corden and Warr (1981). See also McKinnon (1976)and Corden (1971 and 1981) for further development of the relevant theory. Readersalready familiar with this body of theory may wish to omit this seciion.56


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FIGURE Resource Boom and Exchange Rare Prot$ctionion-tradeables

T Tlevel of real absorption, measured in terms of non-tradeables, isN, and the price of tradeables relative to non-tradeables is given bythe slope of the com m on tangent a t th is poin t , p,. The expansionpath OY represents the pattern of demand when relative prices areheld a t p, an d aggregate expe nditu re is increa sed. Th e positiveslope of OY reflects the assumption that both tradeables and non-tradeables are norm al goods.

Absorption may be measured in terms of tradeables by extending pA to th ehorizontal axis.T h i s is why tradeables have been represented on the horizontal axis in thediagram. rather than on the vertical axis as is more usual. In the more usual formatthe slope of a tangent represents the non-tradeables/tradeablen price ratio , which i sinconvenient here.

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I t is helpful f irst t o use the diagram t o il lustrate the ad justm en trequired to eliminate a balance of payments deficit . Suppose, forconvenience, that n o petroleum bo om h as occurred an d thereforetha t N T is the relevant prod uction possibil ity f rontier . Let theinitial tradeables/non-tradeahles price rati o he given by th e slope ofN T at D, p o, w h ich is less t h a n p P r o d u ct io n oc cu rs at D andassuming the non-tradeables m arke t clears, con sum ptio n will occurat point C , ying at the point where a line dr aw n horizontally to th eright fro m D cuts an indifference curve having th e slope p, T h usp, ,=, p,. Th e distance D C now represents the balance of paym entsdefici t o n current acco unt - he degree by which the con sum ptionof tradeahles exceeds their production - hich results. A rise inth e tradeablednon-tradeables price ra tio (fro m p, to pA ) is neces-sary to eliminate this deficit . This permanent change in relativeprices might be achieved by domestic deflation at a fixed exchangerate or by devaluation followed by a less th an com m ensurate r ise inthe domestic price level.T h e schedule N T now illustrates p rod uc tion possibilities afte rthe oi l price bo om . Since few domestic facto rs of pro duc tion a reemployed in Indonesias p etro leum sector, th e bo om is representedas a horizontal shift in the production possibilit ies schedule. Thes lope of N T a t po in t B is the sam e as that a t po int A, but B is notan equil ibr ium. Prod ucers ar e willing to prod uce at this po int giventhe ini t ial pr ices , but this combination of t raded and non-tradedgo od s will no t he consum ed a t these prices. The se relative pricesca n be maintained only if ab sorp tion is restrained. In pa rticula r , ifnon-tradeables m arkets clear , as we expect , consum ption m ust bea t A and there will be excess supply of tradeahles (a balance oft rad e surplus o n cur rent account) o f the a m oun t A B . Th e level ofab so rp tio n, exogenously given in th e present discussion, mu st beheld at N,.

I f full abs orp tion is t o occur, the tradeahles/non-tradeahles priceratio must fall . The new equilibrium will be at point C , at whichab sorp tion is N, an d the tradeablednon-tradeablesprice r atio willhav e fallen t o p,. T he crucial po in t is th at in th e non -petroleum sec-tor of the e con om y, as indicated by th e old prod uc tion possibilit iesschedule , NT , product ion has moved f rom A to D. The non-tradeahles sector has expanded, but the non-oil t radeables sectorha s con tracted. This occurs in spite of the fact that nat iona l incomehas r isen. This contraction in the non-oil tradeables sector, theDutch disease, is achieved by reduced profitability in that sectorand this represents the heart of the adjustment problem.

See also Corden and Neary (1982) and C a si n g andWarr (1982) formore detailedanalyses of th e Dutch disease.58


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On the o ther hand, i f absorpt ion does not occur , consumpt ionremains at A, product ion occurs a t B, and the price ratio remainsp,. Reserves wou ld then be accum ulated ind efinitely at th e ra teA B . The benef i t s of the petroleum boom, in terms of, increasedconsum pt ion , a re then defer red , and no cont rac tion of the non-oiltradea bles goods sectors occurs.Acco rding to this class of m odels, the prices of tradeables will bedetermined by their intern ationa l prices, the exchange rate, a nd a nytariffs or other taxes which may be present.O Non-tradeablesprices are determined by domestic supply and demand condit ions.The objective of exchange rate protection is to prevent the trade-ableslnon-tradeables price ratio from continuing to decline as theresource boom proceeds. It would be unrealistic to expect that thisprice ra tio could be kept at pA , i ts value be fore the bo om occ urred ,bu t a price ra tio as close t o p,as possible in th e interval between p,an d p, , or at least delayed tr an sitio n tow ard s p, , is what is ho pe dfor .Two simple ways by which this could in principle be achievedare:(a) Maintaining a fixed exchange rate and restraining monetarygrowth. The fixed exchange rate holds the prices of trade-ables constant (assuming international prices are constant)while the m on etary restraint acts o n the prices of no n-tradeables. Un der this policy w ha t has t o be prevented is th einflation, necessarily concentrated in the prices of non-tradeables, which would otherwise follow from absorptionof the petroleum revenues under a fixed exchange rate, andwhich allows the tradeableslnon-tradeables price ratio todecline en route t o p o in t C.(b) A combination of devaluation and restraint of subsequentmonetary growth .T he effects of policy (b ) will be m ore imm ediate, but this policywould presumably not be considered unless policy (a) had alreadyfailed. If m on etary gro w th cann ot be restrained it can be expectedtha t a devaluation will have only tem po rary effec ts on the dom esticprices of tradeables relative to non-tradeables. Tradeables pricescan be expected to rise, with so me lags, in response t o the devalua-t ion , but compensating increases in non-tra dea bles prices can beprevented only if domestic demand is restrained.The level of real absorption has so far been given exogenously.The absorp t ion approach and the mone ta ry approach todev aluatio n provide alternative ways of loo king at the force s deter-

Commodities subject to quantitative restrictions are an obvious exception,which is discussed fur ther below.59


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mining i t . Taking the absorption approach f irs t , suppose thatm on etary an d fiscal policies w ere adjusted so as to keep the level ofmoney expenditure constant. Following a devaluation, the r ise intradeables prices would then affect the demand for non-tradeablesin two opposing ways. On the one ha nd, there would be a n increasein dem and fo r non- tradeables o n account of the dem and sw itchingeffects of the r ise in tradeables prices, and on the o ther h an d , the rewould be a reduction in demand on account of its disabsorptioneffects . These disabsorption effects result f rom the fact that byraising the prices of tradeables the devaluation has raised theaverage price level and consequently reduced real expenditure.Non-tradeables prices may rise, but this will not be sufficient torestore the original t radeablednon-t radeables price ratio . B ut if thedomestic monetary authorities now permit domestic credit toexpa nd sufficiently to restore the original level of real expenditure,the relative price effects of the devaluation will be eliminated,allowing fo r possible lags in ad justm ent.T he monetary approach focuses upon the fac t tha t the devalua-tion, by raising the domestic prices of traded goods, reduces thereal value of current money balances (a stock variable) belowdesired levels . This induces hoa rding of m oney an d , if the nom inalmoney supply is held constant, this implies reduced real expen-ditures . At th e tradeableshon-tradeables price ratio holding b eforethe devaluation there is excess supply o f non-tradeables and theprice ra tio m ust rise to clear the non-tradeables market (Dornbusch1973). Th is continu es until th e stock of real m oney balan ces returnsto its desired level, a fte r which th e tradeableshon-tradeables pricerati o will return t o its original value (again allowing for lags). Butthis ad justm ent process is at tenuated if the dom estic mo ney sup plyis increased following the devaluation. There would thus be asmaller reduction in real expe nditure in response to the devalu ationand a smaller effect on the tradeables/non-tradeables price ratio.Prolon ging th e relative price e ffects of the deva luation requiresavoidance o f a monetary expans ion. Th e usual, an d somew hat mis-leading, way of stating this is that the monetary effects of thedevaluation must be sterilised, at least partly. The implication isthat the government must run a budgetary surplus and a higherpayments surplus ( lower def ici t) on current account than wouldotherwise have occurred. But this is not easily achieved.As reserves grow, political pressures on the government to in-crease spending in particular areas also grow. Moreover , largedevaluations f requently generate expectat ions of subsequent reva-luations. Th is produces speculative capital inflows who se m onetaryimplications must also be sterilised if inflation is to be restrained.

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More serious is the possibility that a devaluation will give rise toexpectations of substantially increased inflation. Unless these priceexpectations are ratified b y monetary growth, unemployment wil lresult. Indeed, if ration al expectations d o not prevail , a devaluationcould generate inflationary expectations sufficient to require fur-ther devaluations later.T o a large ex tent , the problems involved in the effor t to prolon gthe relative price effects of a devaluation are similar to the diff i-culties encountered earlier in the effort to prevent increased petro-leum revenues from being reflected in increased non -trade d goo dsprices. Restraint of domestic spending (and its consequent infla-tio n) is required in each case. It was presumably the relative failureof efforts t o achieve this p reviously, an d the consequent decline inth e profitability of the non-oil trade d goods sector, that had led tothe interest in a d evaluation. Te m po rary relative price effects arethe most that could be expected from such a devaluation, but i t isnot possible, on theoretical grounds, to say how long-lived theseeffects might be. Empirical evidence is required.EFFECTS OF DEVALUATION: EVIDENCE FROM OTHERCOUNTRIESFor com pa rative purposes, this section reviews the li terature on th eeffects of devaluation in other LDCs, particularly as regards itseffects on relative prices. Needless to sa y, these studies suffer fro mthe fac t that th e effects of devaluation are m ixed , in th e statisticalrecord, with the effects of other events which occurred simul-taneously, and it is seldom possible to separate these effects satis-factorily. The attempt to analyse the effects of Indonesias 1978dev aluation, described later , a lso suffers f rom this problem. Butdevaluation is usually such a large shock that i ts effects tend todominate other determinants of relative price movements.In his well-known study of th e effec ts of devaluation in less-developed countries (LDCs), Cooper (19718, 1971b. 1971c an d1973) f ind s tha t between the years 1947 an d 1970 only ten LDCs didnot devalue their currencies at least once. C oo pe rs stu dy focusesu p o n 24 devaluations in 19 countries, mostly occurring in the late1950s an d ear ly 1960s. supplemented by less complete informationon another dozen occurr ing in the late 1960s. He f inds tha t theeffects are diverse, but that in the hypothetical representative

Most of the ten examples were Central American republics with currenciespegged to the US dollar. The only other (non-socialist) countries failing to devaluewere Japan, Switzerland and the United Stales.

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country devaluation is followed by an improvement in the balanceof payments within the first year; the abso lute volume o f im po rtsgenerally declines within the first year, except in cases of smalldevaluations; there is a small and temporary deterioration in theterms of trade;) ' import prices rise quickly in the three or fourmonths following the devaluation, hut this rate of increase thentaper s off m arkedly an d the tota l increase in im po rt prices remainssmaller than the amount of the devaluation even after a year haselapsed, while consumer prices will have risen less than this andnominal wages will have risen by still less.Thus, Cooper finds that one year after the typical devaluationimporters ' margins have fallen - holesale prices of i m po rts haverisen by less th an th e 'law of one price' would predict. T h e prices ofimports have risen relative to the prices of domestically producedgo od s, an d real wages have fallen. The general price level has risen,but by considerably less than 'purchasing power parity', themacroeconom ic counterpar t of th e law of o n e price, would predict.Cooper also observes that devaluations are frequently accom-panied, or quickly followed, by partial liheralisation of tar i ffs andquantitive restrictions, some of which were instituted earlier asad hoc measures t o avoid the necessity fo r devaluation . M ore signifi-cant is the tendency for export taxes to be levied o r increased, parti-cularly on primary commodities. These are intended to tax awaysome of the windfall gains that would otherwise accrue to exportproducers following the devaluation. The windfall gains will he atem por ary consequence of relative price movem ents, b ut the exp ortlevies may be permanent.Fur thermore , Cooper found tha t devalua t ions tend to hefollowed by a depression of economic activity lasting sometimesonly a few m on ths, but often mo re than a year." Co oper was no table to determine empirically the degree to which this was due tothe devaluation itself or to other policy measures, includingmonetary stringency, intended to facilitate the success of the deva-luation, but he did observe that the extent of this depression istypically an unpleasant su rpr ise to the governm ents c oncerned.""Of course, this violates th e 'small country' assum ption present in the econo mic"See also Diar-Alejandro (1965). Eshag and Th orp (1965) and Crockett (1981)."More unpleasant still was [he fact tha t in 30 per cent of cases the gov ernment fellwithin a year, while finance ministers were ieplaced in almost a further 30 per centof cases -excluding those where the entire gorernment fell! In a 'control' group ofcountries not dmal u i ng , Cooper found that the corresponding proportions were 14a n d 4 per cen t, respectively, but these countries p re w na b ly did not suffer the samebalance of payments difficulties present on werage in the devaluiiig group.

models discussed previously.

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Cooper offers a structural (non-monetarist) explanation for thisdepression in economic activity. Cooper (19716) exp lains it largelyin terms of inelasticity in the demand for imports, the inelasticityresulting in part from the vir tual elimination, through protection,of many categories of imports which are close substitutes fo rdomestically produced goods. The increase in their domestic cur-rency prices following the devaluation is accompanied by anincrease in expen diture o n these good s and by reduced expen ditureon home-produced goo ds. A second mechanism is what Coopercalls 'deflatio nary re distr ib utio n' . Th is will arise if the devaluat ionredistr ibutes income towards groups with a low marginal propen-sity t o spend on domestically pro du ced goods-meaning a highmarginal propensity to save, to purchase imports, or both." Thiseffect could outweigh the stimulatory effect of the devaluation onexports, especially if their supply is inelastic in the short run andmerchandise exports ar e smaller than imports.The assumptions under lying Cooper 's reasoning seem to f i t theIndonesian case rather well, as does the argument added byKrugman and Taylor (1978). These authors point out tha t whendevaluation generates additional government revenue (redistr i-but ing the incrementa l income f rom the pr ivate sector to thegovernment) a contract ion in aggregate demand may result ,depending on the government 's shor t r u n adjus tment to therevenue windfall. Increased investment spending could offset theseeffects, but this may not occur in the short run if substantial excesscapacity is present in those sectors benefiting initially from thedevaluation.These structuralist arg um en ts all involve a reduction in aggregatede m an d, in real terms, following the devaluation. Th e m one tar is targument, rest ing on increased hoarding of money fol lowing adevaluation and a consequent reduction of real e xpen diture, pro-vides an alternative way of reaching this result. A fur ther moneta-rist p oin t, focusing o n supply side effec ts, is tha t by reducing theteal value of the money stock the devaluation increases somewhatthe velocity of circulation and this makes credit more difficult toobtain, for businessmen as well as others. With interest rate con-trols this takes the form of credit rationing and economic activitiesdependent on credit are inhibited. Hence, output falls . Whicheverexplanation is offe red , th e implication is tha t in the shor t run therate at which resources are released from the (contracting) non-

"This phenomenon appears to have been important in the cases of the 1959devaluation in Argentina (Dial-Alejandro 1965) and the 1957 devaluation in Finland(Gerakis 1964).

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traded goods sectors exceeds the rate at which they are absorbedinto the (supposedly expanding) traded goods sectors. Unemploy-ment results.Referring to the accounting identity Y - E = X - M , where Ydenotes income. E denotes exoenditure. X denotes exvorts and Mdenotes imports , an economic slump fol lowing a devaluationmeans that the desired reduction in expenditure is achieved at thecost of an undesired reduction in inco m e as well. T he evidence isclear that the balance of payments on current account typical lyimproves following a devaluation, '* so the effect o n expenditure isthe gre ater, bu t th e possible side effect o n inco m e should not be dis-missed. Of course, all of these deflationary effects of the devalua-t ion could be offset by a n expansionary m one tary an d fiscal policy,bu t this would undermine the desired effects of the devaluation.Clearly, when the devaluation is followed by a domestic contrac-t ion , the pressure o n the authorities to increase domestic spendingand expand domestic credit would be hard to resist .Th e ef fec tsof devaluation o n relative prices were studied in mo redetai l in an im po rtant paper by Connolly and Tay lor ( 1 9 7 6 ~ ) . on-nolly and Taylor examined eight devaluations in five countries,selected on the availability of adequate price statistics. All eightdevaluations occurred between 1962 an d 1970 and their averagenom inal m agni tude was 51 per cen t, expressed in terms of th e hom ecurrency. By coincidence, this almost exactly matches Indonesia's1978 dev aluatio n, making t he Connolly an d T aylo r study especiallyrelevant for com para tive purposes.

Co nno l ly and Taylor present qu arter ly da ta o n average wholesaleprices o f imp ort s, w holesale prices o f expo rts , consum er pr ices andgeneral wholesale prices, b efo re and a fter the devaluation. W e shallfocu s on the first three of these. W holesale im po rt and export priceindices are used t o indicate mo vem ents in trad ed goods' prices,while consumer price indices capture a substantial component ofno n-tr ad ed g oo ds a n d services as well as retail prices of t raded con-sumer goods.The Connolly-Taylor results generally complement Cooper's.The data are replotted in Figure 2 and the three price series pre-sented are indexed with the quarter before the devaluation"

"For example, see Cooper (1971a), Connolly and Taylor (19760 and 1976b) andDonovan (1981)."Data for the quarter in which the devaluation occurred (quarter 0) will includesome price response to the devaluation itself, so the quarter before this would seemto be the most appropriate base64


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FIGURE Devaluation and Prices in O ther LD C sa(Quarter befo re devaluation = 1001150- Index

130-120 -110-loo -

, Quarter90-k'/ I I I I I I I I I I I I l l- 9 - 8 - 7 - 6 - 5 - 4 - 3 - 2 - 1 0 I 2 3 4 5 6 7 8'Redrawn from Cannolly and Taylor (1916a).

(quarter - ) indexed to 100. The da ta may be summarised asfollows.(a) T he two years befo re the dev aluat ion occurred were cha rac-terised by a moderate decline in the ratio of the wholesaleprices of imports and exports to the consumer price index(CPI). In each case the average decline was around six percent .(b) In the quarters immediately following the devaluation allthree price indices rose at a greater rate than before, hutimport and export prices rose faster than consumer prices.(c) The ratio of import and export prices to the CPI reached amaximum after two quarters . At th is poin t, the im po r t /C PIprice ratio had risen 22 percentage points above i ts valueimmediately before the devaluation. Subsequently, therelative price effect tapered off in a manner analagous toa process of radioactive decay with a half-life (the timetaken for half the init ial effect to vanish) of four quar te rs ,measured from the t ime when the peak was reached."(d) Tw o years af ter the deva luat ion ( the limit of the C onn ol ly-Taylor da ta) the impor t /CPI and expor t /CPl pr ice ra t ios"This is seen more easily by plotting the import/CPI and export/CPI price ratios.

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had returned t o their values two years before the devalua-tion , but still exceeded their values imm ediately prior t o thedevaluation. I 9(e) Import prices rose faster than export prices immediatelyfollowing the devalua tion. O n average, there was appa rentlysom e deterioration in the terms of trade, confirming C oope rsfinding, but this effect had vanished within six quarters ofthe devaluation.

INDONESIAS 1978 DEVALUATION: RELATIVE PRICE EFFECTSBackground lo the Devaluation. T he econom ic and polit ical back-ground to the devaluation has been thoroughly described else-wh ere, bu t it is help ful to review some o f the relative price move-me nts occu rring in the years preceding the devaluation. Th e first sixrows of Table I show the movements of wholesale prices in Indo-nesia o ver the eight years prior to th e devaluation . Co nsum er pricesfor Indonesia as a whole are not available f o r this per iod a n d as aproxy the next two rows of the Table present consumer prices inJakar ta ( the Jakar ta cos t of l iving index) and the housing com-ponent of this series, respectively. T h e Ja k ar ta ho usin g price seriesis intended to serve as a proxy for non-traded goods prices.Th e ratio of im po rt prices to consu m er prices fell from a n indexof 100 in 1971 t o 73 in 1978, while the impo rt /housing pr ice rat iofell from 1 0 0 to 87. Alternatively, if 1974 is used as a base instead,these two ratios fell from indices of 100 in that year to 78 and 65,respectively, in 1978. Over this period, the decline of importedgoods prices relative to tho se of n on-traded goo ds and services ( thesource of the Dutch disease) was pronou nced . T his was som ewh atless true of non-petroleum export prices. The ratio of these pricesto consumer prices declined from a base of 1 0 0 in 1974 t o 84 in1978. Among the domestic industry groupings indicated, agr i-cu ltural wh olesale prices rose in relation t o consu m er prices w hilethose of mining and quar rying and those of manufactur ing fe l lrelative to consumer prices.The final price series shown is often referred to as an index ofcompetitiveness . I t is obtained by taking the nominal exchangerate between Indo nesia and each of i ts m ajor trading par tners andm ultiplying it by the ratio of consu m er prices in the foreign co un tryto consumer prices in Indonesia. The resulting numbers are thenaggregated using the various countries shares of Indonesias trad e

Connolly and Taylor (19760, p. 857).See especially Sukadji (1973); Aghevli (1977); Arndt (1977, 19780, 19786 a d1983); Dick (1979); Kingston (1979); McCawley (198Oa and 1980b).66


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T A B L E Price Movements Preceding the Devaluation, I971-19781971 1972 1973 1974 1975 1976 1977 1918

Imports - holesalepricesExports - holesalepricesExports, non-petroleum -wholesale pncesAgriculture - wholesalepricesMining and quarrying- holesale prices

Manufacturing-wholesale pricesJakarta consumerprices - eneralJakarta consumer

prices ~ housingCompetitivenessindex

I IO

1 I9105I181 1 3110106101100

140I79166159I25I54140I I494

18431721921816418919613817

U X )

36818225419520223417370

215393226321210238280216

63

225447290392237265311254

61

239455306423257289326274

73a1978 data cover the pre-devaluation period of January to October.Sources: Central Bureau of Statistics, Indikoror Ekonomi, various issues, andthis case 1971 covers October to December only.International Monetary Fund, Inlernarionol Finonciol Slotrslics, various issues.as weights. If purchasing power pari ty held at all t imes th iscompetitiveness index w ould be c on stan t, so mo vemen ts in it can bethought of as capturing deviations from purchasing power pari ty.A decline in this type of index is usually interpreted as reflecting ar ise in costs in the hom e coun try in com parison with those abroadan d so a decline in the competitiveness of producers of t radedgoo ds in the hom e count ry .

Th e basis of this reasoning is app are nt if we imagine the no m inalexchange rate and foreign prices to remain constant and thedomestic price level to rise. The index of competitiveness falls,bu t w hether the tru e competitiveness of a n y group of producers hasrisen or fallen dep ends entirely o n the com position of th e price rise- hethe r th e prices they receive have risen or fallen relative to th eprices they p ay . Now if trad ed go od s prices ar e determined by inter-

For discussion of the measurement issues involved in this type of index seeBranson and Katseli (1982) and Maciejewski (1983).67


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dedBy:[UniversityOfMelbourne]At:06:482October2007

natio na l prices and the exchange rate (the law of on e price) theywill have remained constant and so the rise in the domestic pricelevel will hav e been d om inated by rises in the prices o f non-trad edgoods. The competit iveness of f i rms producing non-traded goodsand services will have improved (on average) while tha t o f t radedgoods producers (exports and import substitutes) will havedecl ined.T he decline in the com petitiveness index fro m 100 in 1971 t o 73in 1978 occurred in spite of the depreciat ion of the US dollar , towhich the rupiah was pegged, relative to the currencies of Indo-nesias oth er trading par tners , principally the Japanese yen. Onthis account, the trade-weighted rupiah cost of foreign exchangerose f ro m an index of 100 in 1971 to 135 in 1978. But the rat e of in-flation in Indonesia over this period was almost double that of i tstrading partners. Prices in Indonesias trading partners rose from100 to 181 over the eight year period, while in Indonesia they rosefrom 100 t o 334.Th is com petitiveness index is discussed critically in a later sec-tion of this paper and in the Appendix, but i t is worth noting thatcalculations based on this type of index, showing a decline similarto that indicated in the Table, played a n impo rtant part in thepolicy discussions which preceded the devaluation. According toone source , the Internat ional Monetary Fund and the Dutchgovernm ent argued at the Inter-Governm ental Gr ou p for Indon esiameetings in mid-I978 essentially in favour of a devaluation torestore competit iveness, drawing on these sorts of calculations,while the World Bank argued against i t . *Th e policy discussions preceding the de valuation hav e been sum -marised in Arndt (1977, 1978a and 19786). Arndt did not favour adevaluation for protective reasons and set o u t his argu m ent and hisalternative policy recommendation options in Arndt (1977). A nimportant argument in this debate, spelled out by Paauw ( 1 9 7 8 ~and 197863, made the case for devaluation partly in terms of th eincome dis tr ibutional effects o f expanding em ploymen t in the pro-duction of labour intensive non-extractive exports. Unfortunately,Paauws t reatment did not dis t inguish between the short-run andlong-run relative price effects of a devaluat ion, but a significantfurther point was later suggested by McCawley (19816, p. 155) .McCawley observed that several of Indonesias major non-extrac-

>T he ise in the index over the 1977 to 1978 period reflected an acceleration of thisprocess through appreciation of the yen relative to the dollar.Far Emfern Economic Review. June 16, 1978. Note aim the wording of theexplanation far the devaluation given by the Director of Bank Indonesia, cited infootnote 3 , above.

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t ive exports (perennial crops such as rubber, coffee, palm oil andcopra) have low short-run supply elasticit ies and that 'even ifrelative prices remain favourable the real output of these sectorsmay not begin to rise markedly for several year^."^ Given thissituation, what is relevant for the supply response of these indus-tries is the expectations of producers about future prices for theirpro du ct in relation t o their costs. Extending M cCawley's po int, its e e m l ikely tha t i f prod uce rs in these industries expect the f avo ur-able relative price ef fec ts of the devaluation to be only tem porary,i ts st imula tory effects on investment and pro du ction in those indus-tries may in fact be negligible.T he 1978 devaluation an d its imm ediate afte rm ath are discussedin detail in Dick (1979). The devaluation was preceded by somecapital outflow and loss of reserves, but especially considering themagnitude of the devaluation and the official explanations givenfor it, it seems clear that this temporary decline in reserves hadmore influence on the t iming of the decision than on the actualdecision to devalue. The devaluation was accompanied by someliberalisation of import controls, particularly as they affectedexport producers, but contrary to the apparent object ives of thedevaluation it was soon followed by price controls on severali m p o r t e d c o m m o d i t i e s a n d d o m e s t i c a l l y p r o d u c e d i m p o r t -substitutes. Some of these controls lasted several months. Exporttaxes were raised for several agricultural commodities in an effortto extract some of the windfall gains resulting from the devalua-t ion , a nd in ad dit ion , quanti ta t ive export controls were temporarilyimposed on some commodities to protect consumers from priceincreases due to the dev alua tion. Needless to sa y, this co nfu sion o fpolicy did not help to restore the business confidence which thedev alua tion itself had already dam age d.Comparison with Other LDCs. For direct comparison with theCon nolly-Taylor results on the relative price effe cts of devaluationin o ther LD Cs , the Indonesian da ta are presented in Figure 3 in thesame format used in Figure 2 . I t should he noted tha t the expor tprice series used excludes petroleum. T he following conclusions canbe drawn regarding the 1978 devalua t ion .(a) In the two years prior to the devaluation the ratios of th ewholesale prices of imports and exports to the consumerprice index did not decline to the extent observed by Con-nolly and Taylor .

"Rubber is a partial exception to this, Since there is the possibilit) of increasingthe rate of tapping in one year at the expense of available supplies in the followingyear.

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FIGURE Devaluation and Prices in Indonesiaa(Third quarter 1978 = 100),. xports( (non oil)

iii300

Quarterly data, Qt I 1977 - t I 1983(h) In common with Connolly and Taylors s tudy, in the quar-ters immediately following the devaluation all three priceser ies rose more rapidly than before but import and exportprices rose faster than consumer prices.(c) The ratio of import prices to the CPI reached a maximum

after two quar ters , but at this maximum the rat io had r isenby only 17 percentage points above its pre-devaluation value,co m pare d with 22 per cent in the Connolly-Taylor stud y. Th esubsequent erosion of the relative price effect had a half-lifeof roughly a fur ther ten quar ters , compared with Connollyand Taylors four .(d) In co m m on w ith the Conno lly-Taylor results, th e im po rt/C P I and export/CPI price ratios still exceeded their pre-dev aluation values tw o years af ter the devaluation. A t thistime the im p o rt/ C P l price ratio exceeded its pre-devaluationvalue by 12 percentage points, compared with Connolly andTaylors seven.(e) Export prices rose faster than import prices following thedev aluation . This was so even thou gh t h e export price seriesexcludes petroleum and so doe s no t captu re the effect of th e1979 second oil shock. The improvement in the terms oftrade, con trast ing with th e shor t- run deter iorat ion s observedin the Cooper and Connolly-Taylor studies, reflects the

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fo rtu ito us increases in the in tern atio na l prices of several ofIndonesias non-oil exports which began in 1979,but this wasnot related to the devaluation.(0 The depression in economic activity following a devaluationobserved by Cooper, Connolly and Taylor and others wasno t discernible in In don esia. If such a n effect was present,it was swamped by other forces, including the improvementin Indonesias non-oil terms of trade.In summ ary, a lthough the magni tude of th e relative price effectsof d eva luation seems t o have been sm aller in Ind one sia, the effect

was more prolonged. This difference in the pat tern of priceresponse in Indonesia and the countries studied by Connolly andTaylor appears to reflect (a) the price controls introduced soonafter the devaluation, which reduced th e imm ediate im pac t ontraded goods prices (this seems to account for the lower peak inIndonesias imporr/CPI price ratio) and (b) the m onetary restra intcxercised in the post-devaluation period (which presumablyaccounts fo r the longer du ration of the relative price e ffe ct) . Th egrowth of Indonesias nominal money supply fell well behind thegrowth in consumer prices throughout 1979.26In com paring the C m nolly-Tay lor resul ts with those of Indo-nesias 1978 devaluation i t must be recognised that most of thedevaluations studied by Connolly an d Ta ylor occurred from initialpositions of disequilibrium - alance of payments deficits - n dthat in these cases some degree of permanent increase in th etradeables/non-tradeables price rati o was required for restoration ofbalance of payments equilibrium. This is somewhat different fromth e Indonesian case, where the intention was to crea te an d then t oprolong a disequilibrium - balance of paym ents surplus. M ore-over, Indonesias devaluation was soon followed by a second oilb o o m ( th e O P E C oil price increases of 1979180) an d by unforseenimprovements in the intern ation al prices of several non-oil exportsas well, all of which presumably reinforced the underlying Dutchdisease pressures which had led to the devaluation. Other things

This is clear from data on gloss domestic product and its composition presentedin Central Bureau of Statistics, Nor!onol Income of Indonesia, various issues. GDPat constant prices continued 10 grow at roughly its trend rate throughour the late1970s and early 1980s. This i3 also true of G D P in manufacturing. The rapid expan-sion of manufacturing following the devaluation anticipated by Garnaut (1979) doesnot seem to have occurred.See Chart 1 in Warr (1980. p. 28). The years indicated on the horizontal axis ofthis diagram are mis-labelled and should read 1978, 1979 and 1980. See also Arndt(1983) and Arndt and Sundrum (1984). For a cross-country em pirical analysis of thisissue see Aghevli and Khan (1980)

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being equal (subsequent monetary policy in particular), a devalua-tion would have been expected to have smaller and less prolongedrelative price effe cts in th e 1978 Indonesian case tha n th e devalua-tions studied by Conuolly and Taylor.Con sidering all this, the degree to which Indonesias de va lua tionseems to have influence d relative prices in the desired direction , andmore particularly the duration of these effects, is quite impressive.Relative Prices of Traded and Non-traded Go ods. It is not diffi-cult to con struc t indices of relative price m ovem ents w hich imp roveup on the Connolly-Taylor exercise. N an-tra ded com pon ents o f theconsumer price index are available but since consumer prices in-clude substantial retail margins they are not ideal indicators oftrade d go ods prices. W holesale prices of imported comm oditiesprovide a preferable source. We shall first discuss some indices oft radeables/non-tradeables price ratios using selected commoditiesas proxies fo r general price movements and then proceed to theconstruct ion of a more general aggregated index.Indices o f t r ad ed ho n- tra de d price ra t ios have been constructedfo r several comb inat ions of specific t raded a nd no n-traded g oo ds,Obviously, the selection of commodities involves some arbitrari-ness a nd the results o btain ed d o depend o n this selection,* but aco m m on p att er n is observed o f initial relative price effects reachinga maximum after three to f ive months, fol lowed by the gradualdecay of this impact. By the t ime of the March 1983 devaluat ionm o s t o f these indices had reached or almost reached their approxi-mate values before the 1978 devaluat ion. In Figure 4 we presentthree examples. These are (a) the Indonesia-wide wholesale pricefor imported textiles relative to the housing component o f th eIndonesia-wide consumer price index, (b) the wholesale prices ofimp orted t rans po rt eq uipm ent relat ive to the same housing seriesand (c) the wholesale prices of imported cement and cement pro-ducts relative to housing. They are labelled Tex/H sg, T ra n/H sg an d Cem/Hsg, respectively, in the diag ram .T he arb itrarines s involved in selecting particular com bina tions oftradeables and non-tradeables as above can be overcome by con-structing such indices at a m or e aggregated level. Figure 5 presentssuch an index, constructed as follows. The index of tradeablesprices is the Indonesia-wide wholesale price index for importedcommodities. Export goods prices are excluded because they are

Judging from the data presented by Amdt and Sundrum (19751, the results T h e series labelled competitiveness in Figure 5 should be disregarded for the

rould also be affected considerably if region-specific data were used.present. W e return to i t in a later sub-secrion.

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FIGURE Three Indices of Tradeables/Non-tradeablesPrice Ra tiosa(October 1978 = 100)

no 1I \ e d H s gYear1977 I 1978 I 1979 I 1980 I 1981 1982 I

aMonthly data, Jan. 1977- eb. 1983FIGURE Aggregate Tradeables/Non-tradeabies Price Ratioand 'Competitiveness'a

(October I978 = 100)Index I.

I 4 0 - i \i !130 - j (i120-110-

100 -90- J '

/-./J-. Year1977 I 1978 I 1979 I 1980 ' 1981 I 1982 I

I Index I.i \i !130 j (i120-110-

100 -90- J '

/-./J-. Year1977 I 1978 I 1979 I 1980 ' 1981 I 1982 I%onthly data, Ian. 1977- eb. 1983.

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more rubject than import prices to international pricc fluctuarionswhich arc unrelated to the devaluation. I he iridex of non.lrddeahles'pr i ics is drawn ironi doniponents of the son,unier p r i x index.From A p r i l IY79 o n n : i r d \ the C'entral Ihircait 0 1 Siarim;s (CHS)has pubi:sIIed muot l i l y d.it:i gi\ i i ig 26 componen t , u i the Indone \t a -n i d c .'ats .rm e r p ri< e i n h . kri)m t l i i $ ,crirs ; i n iiidcx oi nun- t radedgooJ,' pri;es h3 \ been son,tru:ted iroin eight ( ' P I :oinponentsseemingly belonging to tht. n o n - t r a d c J c a t e g x y . ' ' P r i o r io ,\prilI979 d a t a were piihliditd Cor a ' . m i ,)t l i \ i n g * indeu im variouscities. diag6rcgatc.I i o o i i l y io u r :ategorich' Iiouring . IooJ. ;l,)thinga n d mi~&'llmr.oi.~. I' iip iihli ,hcd price d a ta u$ins t h e po,t.April19'Y ('1'1 i l a \ ~ i i i c a t i m iaie been ohrained i r m i iltc CHS i o r thep e r i d l a n u n r ! IY77 I O Zpr i l 1979, hut rclaiing t d Ja k a r t a o n l y ,a n i t i ic ,~'d a t j a r e used in the .~;il;uIatiori~underlying I.igurc 5 .

I he w r k , 4 1 m n n I'ipiire 5 indi-ate, that the price ra tiJ r c x h e da peak i i \c m m t h i t e r ih edev a lua t ion . h ) Hhish time i i Iiad riwnb y 23 pcr;ctitdpc pt>inr* abovL, its v . 1 1 ~ cfore the donl i ia t ion .After this. ilic c i t e c i icll a u d ! g i n J u a l l y id this prodc,? oi ducayh ad 3 hal t - l i ic 01 approximntcly a further 25 m o n t h > . By the t imeid the \ldr;li I Y X 3 d e w lu x io n , r o u g h ly o n e - io u r th ol the iniiialre la i i \e pride e iiesr re m a in d .W e now turn hrieil? 1 . 1 the impact of thc de\aluni ion on parti-ci i lnr sector required I S , 16 and 17 month, , respec-ti\cl!. C o n m i i c r pri::h had r i w i hy a com pnrxh le amourti dIrcr 23month.;. 1he se.'oir.l point i ) that even h! i h r . lime o i the \ldr;h1983 dc \a lua t ion the ra tios (ii h c b \c ra gc n I i . 1 l c 4 e prizes oi rhesesector.. to !he C P I had \ t i l l n o i retitrncJ to their pre-dc\,aluaiion\ d u e > . I hew ra t io , c\:ccdcd their pi:-dc\dluation v d u c r hy:mnniif'd;turing. I O per d i t ; mining an d qiiarrying, I 3 pcr x n : andayriarlrurc. 22 per im . Oi .'otir$:. r h a e s e a o r - n id e pr iic m w e -m e i i t r \\r.rc int1ucn;e.l h! nian! t x t o r s o th er i h a n the devaluationa n a i t \ \odd be a pro% ~ ) \c r , in ip l i i .aa t iun o sa) that an! one ofthew seaor , p rdu :ed o n l y 'tr:t.kJ' :omitioditir.s. Nererrheless,

" r h r . i c ~ ~ ~ , m m o d i r i n a o dheir rerpn.tireacightr. h=, ' ,~Jn ihr \ , c i eh i ,u~rd in he.on.Iru.'imn o ~ ' ~ h c ( ' l ~ l ,rc r ~ o l 1 . 2 R%.\ e ~ c u b l e . - . Y Q o , r u k I 5 4 . 5 O 1 v i i i J r i i i h \ ' Y %. mcJ,:d :arc.' .I$' . .mJ d K 3 l l o n8 3 '

, I ~ J ~ ~ r c h 3 l ~ o p ~ r : ~ i ~ o n ~1 W ,mal

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FIGURE Components of Wholesale Price Index andConsum er Pricesa(October 1978r-_--Index22 5 I AgricultureI

I507 5 1

aMonthly data, Jan. 1977 - eb. 1983these observations do suggest that the validity of the 'law of o n eprice' assumption requires closer examination.Traded Co m m od ities and the Law of One Price. An assumpt ionof the conventional analysis of devaluation is that the prices ofdomestically produced 'traded' commodities will respond pro-portionately t o a devaluation. This assumed price response has twocomponents. The first is the response of the domestic prices ofcomm odities actually exported an d im po rted, and th e second is theresponse of the prices of domestically pro duc ed imp ort-su bsti tutesto increases in the prices of impo rts . T he 'law of one price' assump-t ion encompasses both com pone nts, and b oth are open to quest ion.The second component has been questioned by Arndt (1979), whogives two reasons for possible violations of its premise^.'^ First, thedomestic and imported goods may he imperfect substi tutes, andsec on d, the local prices o f domestically produced goods may he lessflexible in the sho rt run than the prices of im ports . The first poin t iswell understood and is equivalent to saying tha t the dom estic com-modity is not 'fully traded'. But the second point is an interestingone with important implications for the analysis of devaluation.A rnd t mentions inflexibil ity d ue to government price controls an d

"'See also Isard (1977) and.Gregory (1978)75


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also temporary inflexibility arising from the pricing policies of im-perfectly competitive domestic firms. Obviously, the mechanismsinvolved in these tw o cases are differen t, bu t the implication A rn dtdraws is that following a devaluation there will be a divergencebetween the prices of imp orted g ood s and their domestic substi tuteswhich will be temporary but which could last for a considerabletime.A n a ttem pt t o test this price divergence hypothesis with da tafrom th e 1978 devaluation is complicated by th e fac t that someprice controls were introduced soon after the devaluation (Dick1979, pp. 4 - 7 ) , an d th e controlled prices included no t only those ofsome domestically p rod uce d go od s, as envisaged by A rn dt, b ut alsosome imported goods as well. T h e latter co ntro ls applied no t onlyt o stocks which were purchased p rior t o th e devaluation bu t also t odistribution and profit margins which were considered excessive.Nevertheless, it would seem tha t the bite of the con trols was greaterin the case of domestically produced goods (where they wereapplied at the factary level) than in the case of imports. This isbroadly consistent with Arndts assumptions.A second, and more subtle dif f iculty relates to the dis t inct ionbetween trade d an d non-traded comm odities. I t is natu ral t othink of all impo rted commodit ies as being traded an d to presumeth at a devaluation will raise their do mestic prices propo rtion ately .But commodit ies subject to binding import quotas are an impor-tant exception, in th e short ru n a t least. In their price response to adev aluation these commodit ies are analytically analag ous to n on-trade ab les. This poin t is i l lustrated in Figure 7 .Th e pre-de va luatio n c.i .f . im po rt price in do mestic currency is piand the volume of imports permitted is Q* = Q z - Q , , T h edomestic demand schedule is D, and the relevant ( total) supplyschedule is S,. Th is is the supply schedule o f the domestic industrywith a hor izontal displacement of Q* at all prices above p,. Thedom estic m arke t price is p, and th e owners of im po rt qu ota s receivea rent of ( p, - p , ) Q *. A d evalu ation now raises th e imp ort pr icein dom estic cu rren cy to p;, bu t its effects o n the d om est ic marketprice depend o n w hat happens to the domestic supply and dem andschedules. Th is latter featu re is the sam e fo r these com mod ities asfo r non-tradeables . Sup pose , for simplicity, that in the short runthese schedules d o no t shif t . Th e only change is tha t the hor izonta ldisplacement in the supply schedule now occurs at th e price p,andthe supply schedule incorporates the dashed segments . The deva-luation leaves the domestic price unaffected at p, (provided p:isless than pd ). Th is con trasts sharply with th e usual analysis for

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FIGURE Devaluation and Import Quotas

Qi Q 2 Q 3 tradeables . T h e sale effect of the devaluation in the sho r t run is toreduce the rent associated with possession of import licences to( P, - P ;) Q.Ultimately, as all domestic prices and wages adjust fully to thedevaluation, the dom estic supply a n d dem and schedules become S ia n d DA. These are the or iginal supply an d dem and schedules ver-tically raised by the prop ort ionate am ou nt of the devaluat ion. T h eprice of th e go od will rise t o p;. But in th e m ean time , the behaviou rof this commoditys price will have been similar to that of n o n -tradeables. The relevance of this is that these commodities wouldnot provide a good test of A rndts hypothesis. Even if the assump-tion of sh or t ru n stickiness in the prices of dom estically produc edimport substitutes were true, we would still not necessarily observeany short run divergence between the domestic pricis of importedgood s in this quo ta-restricted catego ry and their domestically pro-

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duced substitutes. U nfo rtun ately , the available studies of protec-tion in Indonesia (e.g. Pitt 1981: Boediono 1983), do notdistinguish between tariff an d q uo ta pro tectio n in their estimates ofnom inal protect ion by com m odity group. B ut in test ing the law o fone price hypothesis this problem must be recognised.I t has been possible to identify f ive manufactured commoditycategories fo r which th e wholesale prices of b oth im po rts and theirapparent domestic subst i tutes are available on a monthly basis .These are: textiles; wood and paper products; chemicals; cementprod ucts ; a nd metal pro du cts . Th e results a re presented in Figure8. They broadly confirm the price divergence hypothesis. Pricedivergence in th e predicted direction occu rs in fo ur of th e five cases(metals was the exception; no discernible divergence occurred) andin two cases (cement, and wood and paper) this effect was quiteprolonged.These statistical series do not provide an ideal test of the pricedivergence hypothesis. Each of the f ive im po rt an d domesticprice series used relates to an aggregate of related com mo dities a n dth e weights used internally within the tw o series are not the sa m e-they reflect commodity shares within those categories. Data in amore disaggregated form would be preferable. Nevertheless, theydo suggest strongly that the strict law of one price assumptioncannot be sustained. I t is especially notable that a considerableper iod was required for the pr ices of both imports and importsubsti tutes to r ise by the prop ort ionate am ou nt of the devaluation.T he domestic im port-sub st i tutes required somewhat longer in eachcase. T he time required for full response of the prices of impor tsan d im po rt-sub stitutes , respectively, was: m etals, 9 and 13 months ;cement products , 9 a n d 18 months: wood and paper products , 12an d 16 months: textiles, 14 an d I S m onths ; an d chemicals 9 and 13months .

Th is conclusion w ould require some modification if importers pricing polideswere based upon rigid cost-plus mark-u p strategies.These statistics are drawn from Central Bureau of Statistics. IndikatorEkonomi, various issues, 1977 t o 1983. Th e wholesale prices of manufactured goodsare said in Central Bureau of Statistics, Slatisrrk Keuangan don Hnrga-Hargo:Indeks Horgo Perdagangon Besar Indonesra 1971-1978, CBS, Jakarta. 1979 torelate t o domestically produced goo ds on ly , while the wholesale prices of importsrelates only to goods which are actually imported and not to their domesticsubstitutes Con sequently, the tw o series are distinct. Since the comm odity classifi-cation used in these series changed in July 1981. largely by disaggregation of thedomestic m anuf actur ed fo ods series, it was necessary to aggregate some of these newseries to obtain the original commodity categories. The published commodityweights were used in these aggregations.

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DownloadedBy:[UniversityOfMelbourne]At:06:482October2007 FIGURE Import an d Import Subst i tute Price Movem entsa(October 1978 = IOO)

( 0 ) Textiles (b ) M e l d s (c) Wood nnd Paper,~

I20I fI.-.-

16 080 - !'/120 1100 1WYear Year Year

1977 1978 1979 1980 1981 1982 1977 1978 I979 1980 1981 1982 1977 1978 1979 1980 1981 1982T

(d) Chemicals ( e ) Cement ond Productsxes

DomesticImport-00

150 125100

so Yea11977 1978 1979 1980 1981 1982 1977 1978 1979 1980 1981 1982'Monthly data, Jan. 1977- eb. 1983.


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Indices of Competitiveness.Th e account presented above is oneof com parative ly slow dissipation of the relative price effects o f the1978 devaluation. This contrasts sharply with the picture presentedin earl ier commentaries on the devaluation, part icularly thosefo u n d in the Survey of Recent D evelopm ents articles app earing inBIES. In these articles, the discussion of the effe cts of the dev alua-tion o n relative prices has been con duc ted almost exclusively interm s of indices of comp etitiveness similar t o the index describedabove and based on nominal exchange rates deflated by relativeprice levels. This index has also been described as a real exchangerate leading t o some confusion with indices of t ra de ab le sh o n -tradeahles price ratios, which have also been referred to in thisway.For example, Garnaut (1979, pp . 20-21) writes that by June1979 (seven m on ths af ter the devaluation) most of the devaluation-induced gain in the competit iveness of the Indonesian economyhad vanished. This was later supported by Healey (1981,pp . 19-21) who adds that by November 1979 (one year after thedevaluation) only one-sixth of the initial gain in competitivenessremained. Similarly, Gray (1982, p. 30) calculates that by the endof 1981 m o re t h a n 90 per cent o f the init ial effect had gone.Th ese writers were carefu l to sta te the basis for their calculations,but the interpretat ion to he placed upon them has been lef tsom ew hat vague. G arna ut p rovides the clearest acc ount. H e notesthat the competitiveness of particular industries will also beaffected by relative productivity changes, changes in go vernm entassistance levels, term s of trade effects and other factors and thatthe index is useful only in prov iding the m ost general indication ofchanges in relative costs across industries. What has beenoverlooked is that even in the absence of any of the factors Gar nau tmentions, the competitiveness index will he likely to give amisleading impression o f the t rue effects of a devaluation o n com-petitiveness.The competit iveness of domest ic producers depends on therelative prices actually faced by firms in these industries: for theiroutput on the one hand, and the i r inputs on the other . A change(say, a rise) in the domestic prices of tradeables relative to non-tradeahles tends to favour some domest ic producers (producingtradeables) and to harm others (producing non -tradeables). I t is in-

The term real exchange rate is in any Case an unfortunate m isnomer becauseexchange rates represent rates of exchange between currencies and have no realcounterpart analagous to real wages , real interest rates, real money balances,etc.


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correct to describe this as a change in the competitiveness of theIndonesian economy. What is involved is a realignment of com-petitiveness wilhin the domestic economy. Indices of com-petitiveness ar e clearly directed tow ard s the tradeables sector o nly;but even within this sector they will still be misleading.The assumptions implicitly underlying the use of these indicesare: ( a ) that ou tpu t prices within the tradeahles sector are deter -mined by the exchange rate and foreign prices - he law of oneprice, and (b) that input prices (costs) are more or less propor-tional to domestic consumer prices. Users of indices of competi-tiveness typically recognise the limitations of assumption (b), bu tthen ig nore assu m ption (a); the validity of the law of o n e price issimply presumed. But it is shown in the Appendix that when thelaw of one price does not hold in the short run for t raded com-modities these indices will give a biased impression of the pat tern ofrelative price m ovem ents following a d ev alu atio n. They will suggestthat these effects are initially larger and then more rapidlydissipated than is really the case.

Calculations of competitiveness are presented in Figure 5 fo rcomparison with the tradeahles/non-tradeahles price ratio dis-c u s s e d a b o ~ e . ~ omparing the two series, we see exactly thedifference in the pattern of price adjustments predicted by thehy po the tica l exam ple described in the Append ix. T he competitive-ness index suggests a much larger initial effect which then erodedvery quickly. To a considerable extent, the impression of rapiderosion of large initial relative price effects o f devaluation thatearlier writers have given must be seen as a statistical aberration -du e to an artifact of th e competitiveness index itself. T he validityof the index is crucially dependent on the law of one priceholding, and when this fails it is misleading as an indicator ofrelative price movements or the true competit iveness of domestictraded goods industries.CONCLUSIONSIndonesias petroleum bo o m means tha t for the time being at least,and from the standpoint of static economic efficiency, the desiresof consumers a nd the government for t raded and non- t raded goo ds

The index shown is calculated from exchange rates and consumer price indicespublished in International Monetary Fund, lnlernationai Munetarr Stalislics.various issues. Indonesias seven major trading partners were Included, usingIndonesias import shares as weights. The countries included and their respectiveweights are: Japan 0.45, USA 0.21, Germany 0.11, Singapore 0.09, Britain 0.05,Netherlands 0.05 and Australia 0.04.81


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can best b e met w ith fewer resources allocated t o the production oft raded goods other than petroleum and mo re a llocated t o the pro-du ction of non -traded goo ds and services. One interpretation of theuse of exchange rate adju stm en ts in an effo rt to restrain this reallo-cation of resou rces is tha t it reflects the gove rnme nts view tha t theadjustment costs entailed in forcing the non-oil traded goods sec-tors to con tract in the shor t run ( through the mechanism of reducedprofitability in those industries) , only to he required to expandagain later as the petroleum reserves are exhausted, exceed thebenefits of increased consumption that this reallocation makespossible. Less charitable interpretations, focusing upon thepolitical power o f group s w hose interests a re harm ed by such areal ignment of economic incentives, are also possible.Dev aluations a re capable o f achieving temporary protection fortraded goods-producing sectors of the economy at the expense ofnon-tradeables-producing sectors, but these protective effects aresubsequently eroded. In the long run, relative prices are deter-mined by the real forces of supply and demand ra ther than bymon etary p heno m ena l ike exchange rate movements: but the rate atwhich the relative price effects of devaluation are eroded dependsin part on the governments monetary and fiscal policies. The In-donesian dev aluation of November 1978- otivated partly b y theobjective of protecting the non-oil traded goods-producing sectorsof the econo my from the econom ic effects of the petroleum b oom- l lustrates these propositions rather neatly.In the shor t- run, the devaluation was not managed well . Pr icecontrols were introduced for some imported goods and theirdomestic subst i tutes , and quanti tat ive controls were applied tosome exp orts . This was counter-productive - he purpose of anydevaluation is in part to raise the domestic prices of t raded com-modities - nd compounded the loss of business confidence thatthe devaluation had caused. But in the longer term the dev aluationseems to have achieved its protectionist objectives ab o u t as well ascould reasonably have been expected from such a crude policy in-strument. This leaves the question of whether, accepting thegovernm ents object ive of protecting the no n-oil t raded goods sec-tors of the eco nom y, alternative policies might not h ave been m oreefficient j JThe petroleum reserves could have been invested abroad andabsorbed more s lowly, and many economists advocated thiscourse; but the large increases in government spending whichoccurred af ter the 1973/74 oil shock il lustrated the politicalA fuller analysis of the policy alternatives is given in Corden and Warr (1981).

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difficulty of doing this. A lternatively, the rate of petroleum ex trac-tion cou ld have been reduced . This am ou nts to investing in a realasset - etroleum in the ground - nd so speculating on its fu turepr ice, rather than invest ing in f inancial assets abroad. The al ter-native economic merits of these policies depend on inherentlyuncertain projections of the future price of oil , but of the two, thenon-extraction option may have been the only feasible one.

APPENDIX:T W O DEFINITIONS OF T H E R E AL E X C H A N G E R A T EThis appendix aims to clar ify the relat ionship between two com-m only used definitions of the real exchange rate.Definition A is the ratio of an index of the domestic prices ofinternationally traded goods ( tradeables) to an index of thedom estic prices of no n-traded goo ds and services (non -trade-ahles).Definrrion B is the nominal exchange rate adjusted for relativeprice levels domestically and abroad, also known as an index ofcompetitiveness.Thus the real exchange rate by definition A is given by R, =p,/p, where p,and p, ar e indices of dom estic prices o f tradeablesand n on-tradeah les, respectively. Th e propo rtion al change in R, isthus -R, = P, - P N ,where indicates proportional change. By definition B the realexchange rate is R, = Ep*/p , where E is the exchange rate (say,rupiah per $US), p* is an index of foreign prices (say, in $US) and pis an index of th e dom estic price level (in rupiah). Co nsequ ently,

R B = E + e* - 6.For simplicity, we will assume th at domestically consumed goo dscan be divided neatly into tradeable and non-tradeable categories.

Th e do m estic price level will be taken t o he a n index of tradeablesand non -tradeables prices, so tha twhere s is the share of consumer expenditure devoted to non-tradeables.Now consider the response of dom estic prices t o a devaluation,holding foreign prices co nsta nt. Tradeables prices ad just such th at,af ter t ime t , GT = g(t)& where g(t) is a fraction between zero andunity which indicates the degree to which tradeables prices have

83

6 = S E N + (1 - S ) 6 , ,


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adjusted to the devaluation af ter t ime t . Fur the rmo re, we supposethat non-tradeables prices adjust to the change in p, such thatO N = h(t)fi,. If th e dev alua tion is un derta ken for relative pricereasons, and not in response to a real disequilibrium in the balanceof payments, we expect that when equilibrium is f inally restored,say at tim et, g(t*) = h(t*) = 1 . If a real disequilibrium (balanceof pay m ents defic it) was present initially, we expect g(t*) = 1 , buth(t*) < I .Rearranging these expressions, the proportional changes in R,a n d R , af ter t ime t in relat ion to the m agnitude o f the d evaluationwill be given bya n d

RA/B = g(t) (1 - h(t))RB / E = 1 - g(t) (1 - s + sh(t)).

We shall indicate the relationship between these measures bymeans of two hypothetical numerical examples. The two exampleswill differ by whether the law o f on e price (g(t) = I ) holds in theshort run for t raded com mod it ies . In each case, we assu m e s = 0.5.I t is assumed t ha t a devaluation is unde r taken, b ut is not mo tivatedby a balance of paym ents disequil ibr ium. In Table A. l we show inExample I the t ime path of R,& an d R$E when the law of oneprice holds fo r tradeab les at all tim es (g(t) = I ) , but non-tradeablesprices adjust in a gradual and seemingly plausible manner . Thef inal two columns, marked Index A and Index B, show the im pliedbehaviour of ou r two indices of th e real exchan ge rate, calculatedfor a devaluation of 50 per cent and with their pre-devaluationvalues indexed t o 100. Th e t ime per iods indicated should be u nder-s to od to represent analytical t ime, rather t ha n calendar t ime.

Devalu ation and the Real Exchange Rate:A B L EA.l Hypothetical Example It P(t) h(t) R,/? ^R,/& IndexA IndexBI 1 O I 0 .5 150 1252 1 .2 0.8 0 .4 1 4 0 1203 1 .3 0.7 0.35 135 1 I84 1 .5 0.5 0.25 125 1135 I .7 s 0.25 0.13 1 I3 1076 1 1 0 0 1 0 0 100

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The behaviour of the two indices over time is quite similar , theonly difference between them being tha t following the devalua tionthe absolute increase in the real exchange rate by definition B issmaller. Th is occurs because even in the sh or t run the devaluationraises both the no m ina l exchange rate an d th e dom estic price level(through its effects on tradeables prices). Aside from this, calcula-tions based on de finition B (Index B) would provide a good indica-t ion of th e behaviour of relative prices (Index A).Now consider Example 11, in Table A.2. This case is identical,except that the law of one pr ice does not hold in the shor t run.

T A R L E .2 Devaluation and the Real Exchange Rate:Hypothetical Example I It P(t) h(t)1 0 . 2 02 . 5 .23 .9 .34 1 .55 1 .756 1 1

kA/E EB/E0.20 0.900.40 07 00.63 0.420.50 0.250.25 0,125

0 0

Index A Index B1 I O 145I20 1 3 5132 121125 113113 1061 0 100

FIGURE. I TradeabledNon-tradeables Price Ratioand Competitiveness:Hypothetical Example II

130-

120 -110-

100cIi

I

I ~ ....-I I I I I I 1- I 0 1 2 3 4 5 685


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Tradeables prices are assumed t o respond t o the devaluation m orerapidly th an non-tradeables prices, but not instantaneously. So g(t)approach es unity m ore rapidly than h (t) does. Th e violation of thelaw of on e price causes Index B to become an unrel iable indicatorof the hehaviour of Index A.Now suppo se we were to use calculations of Index B to make in -ferences ab o ut the effects of a devaluation on the t radeables /non-tradeables price ratio (Index A ). Th is would lead us to overstate theinitial price effects of the devaluation (t = l ) , and would thensuggest tha t these price effe cts quickly began to diminish when infact tradeables prices were still rising relative to non-tradeahles(t = 2 a n d t = 3). In s ho rt , when the law of o ne price does nothold, calculations based on definit ion B would give a distortedpicture of the p attern of the relative price effects of a devaluation.T h e bias in the com petitiveness index may be und erstoo d in-tuit ively as follows. In the imm ediate afterm ath o f the devaluationtradeables prices will have responded only marginally. But byfeeding the new (higher) exchange rate into the calculation theindex pretends that they have already adjusted in full. S ince neithertradea bles n or n on-tra deab les prices have in fact risen very much atthis stage, domestic consumer prices have not risen much either.T he result is a dram atic increase in the measure of competitiveness,even though the true competit iveness of tradeables producers, asmeasured by the relative prices they actually face, has at this stageimproved only marginally .Following this, as tradeah les prices d o in fact rise significantly interms of non-tradeables, impro ving their true competitiveness, thisfac t is reflected in the index only thro ug h its effects o n the do m esticprice level, causing th e com petitiveness index t o f a l l . Tha t is , theindex misinterprets the actual increase in tradeables prices as anincrease in costs , throu gh its ef fec t on th e price level. This show s upas an erosion of the dramatic (but ficti t ious) gain in competit ive-ness achieved with the devaluation. In its subsequent movementsthe index m akes no distinction between rises in tradeables and n on-tradeahles prices - oth cause the index to fa ll to the extent thatthey affe ct the dom estic price level -a n d so it fails to captu re bo ththe tr ue gain in com petit iveness as tradeables prices resp ond to thedevaluat ion and the la ter erosion of this gain as non-tradeahlesprices hegin to ca tch up.REFERENCESAghevli, B.B. (1977). Money, Prices and th e Balance of Payments: Indonesia1968-73, Journal of Development Sludies 13 (21, p p . 37-57.

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Aghevli, B.B. and M.S. Khan (IYRO), 'Credit Policy and th e Balance of Paym entsin Developing Countries' in W.L. Coats and D.K. Khatkhate (eds), Money andMonelary Polrcre,rm Less Developed Countries: A Survey of Issues and Ew denc e,Pergamon Press, O xfo rd, pp. 685-711A m d t , H.W. (1977). 'Survey of Recent Developments'. Bulletin of IndonesianEconomic Sttidm 13 (3) , p p . 1-33.__ 19780). 'Survey of Recent Developments'. Bullelin oflndonesron Econ om icStudies 14 ( I ) , pp. 1-28.__ 1978b), 'Survey of Recent Developments', Bulletin of lndonesion EconomicStudies 14 (3), pp . 1-23.__ 1979). 'The Modus Operondi of Protection' , Economic Record 55 (149).

pp . 149-155.__ (1983). 'Oil and the Indonesian Economy', in Southeasr Asian Affairs1983, Heinemann. for the Institute of Southeast Asian Studies, Singapare,pp. 136-150.A m d t , H . N . and R.M. Sundrum (1975). 'Regional Price Disparities', Bullerm o/Indoneston Econornrc Srudies 11 (2), PP. 30-69.__ (1984), 'Devaluation and Inflation: The 1978 Experience', Bullelin ofIndonesion Economic S tu d m 20 ( I ) , pp. 83-97.Boediano (1983). Manufacturing Protection in Indonesia, paper presented toASEAN-Australian Trade Workshop, Canberra, August, to be published in aforthcoming volume edited by C. Findlay and R . Garnaut .Branson, W.H. and L.T. Katseli (1982). 'Currency Baskets and Real EffectiveExchange Rates' in M. Gersovitz et 01. (eds), The Theory and Experience ofEconomic Development, Essays in Honour of Sir W . Arthur Lewis, Geo rge Allenand Unwin, London, pp. 194-214.Cassing. 1.H. and P.G. W a n (1982). 'The Distributional Impact of a ResourceBoom', Working Papers m Economics and Economelncs N o . 6 5 , AustralianNational University, April, forthcoming in Journoi of Internotronal Economics.Connolly. M. and D. Taylor (19764, 'Testing the Monetary Approach toDevaluation in Developing Countries', Journal of Political Economy 84 (4),pp . 849-859.~ (19766), 'Exchange Rate Changes and Neutralization: a Test of the M one-tary Approach Applied to Developed and Developing Countries', Economico 46(183). pp. 281-294.Cooper, R.N. ( 1 9 7 1 ~ ~ ) .urrency Devaluution in Developing Counrrres, Essays inInternational Finance No. 86, Princeton University, New Jersey, June .~ (1971b). 'An Assessment of Currency Devaluation in Developing Countries'in G. Ranis (ed.). Governmenr and Economic Development, Yale UmversityPress, New Haven. pp. 472-513.__ 1971c), 'Devaluation and Aggregate Demand in Aid-Receiving Countries'in J.N. Bhagwati et a / . (eds), Trade, Bulance oJPo.vmentr and Growth , North-Holland, Amsterdam, pp, 355-376.

~ (1973), 'An Analysis o f Currency Devaluation in Developing Countries' inM.B. Connolly and A.K. Swoboda (edr), Inrernationol Trade and Money,University of Toron to Press. To ron to, pp. 67-196.Corden, W.M. (1977), Inparion, Erchange Rates and the World Economy,Clarendon Press, Oxford.

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- 1981), Exchange Rate Protection in R.N. Cooper el al . (eds), The Inrer-notional M0nerar.v Sysrem under Flexihle Exchange Rares: Global, Regional ondNotional . Ballingen Publishing Company, Cambridge, Mass., p ~ .7-34.Corden, W.M. and J.P. Neary (1982), Booming Sector and De-ind usrriahration ina Small Open Economy, Economic Journal 92 ( 3 6 8 ) , p p . 825-848.Corden. W.M. and P.G. Wart (1981), The Petroleum Boom and Exchange RatePolicy in Indonesia, Ekonomr dan Keuongan IndoneridEconomrcs and Finoncein Indonesin 29 (31, pp. 335-359.Crockett , A.D. (1981), Stabilization Policies in Developing Countries: SomePolicy Considerations, IM F StnJfPopers 28 ( I ) , pp. 54-79.Diar-Alejandro, C.P. (196% Exchonge Role Devaluarron m o Semr-lndusrrialrzed

Counlrv, M . I . T . Press, Camb ridge, Mass.Dick, H . (1979), Survey of Recenl Developments, Bullertn of IndonesianEconomic Studies I 5 ( I ) , pp. 1-44.Donovan , D.J

exchange rate protection in indo-warr

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