Friedman and devaluations...

This is from Milton Friedman...

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         "                               

                                                                                                                                                                                                                                                                                                                                         In the above paragraphs, Friedman is mostly concerned with disturbances in the external- sector or how to correct a trade-deficit or increase surplus... He is arguing that a policy to lower internal-prices would require unemployment to up and/or decrease wages to curb imports and demand for foreign exchange to offset a deficit... Clearly, we need higher interest-rates or tighter fiscal conditions to furnish such an outcome which would increase unemployment and deflation within the domestic economy... The above discussion in the para’s is mainly concerned with the external-sector and its effect on domestic-economy has been ignored that “what we do when the domestic demand and economy is in trouble?” Even though Friedman has accepted wages as less flexible, he further admits that a severe unemployment may decrease wages too... However, evidences around the world point to nominal-downward-wage-rigidity... Nonetheless, a deteriorating external environment may also be bad for domestic demand and employment, and a higher interest-rate to reduce domestic demand would deteriorate external situation further... A higher interest-rate or tight money could also lower employment and wages, which would reduce demand for imports, as Friedman says...  However, no country chooses domestic unemployment to reduce external deficit and this is not just an inefficient method to correct balance of payments crisis, it is also the wrong way... The purpose of monetary and fiscal policies is to reduce unemployment and increase wages and demand in the domestic economy and the global-economy... Therefore, to correct external imbalance economist apply more money, lower interest-rates, lower unemployment, higher inflation and depreciation to increase exports instead of cutting imports only... the external-devaluation...

Exchange rate or internal-prices are two, but connected with each-other and changes in them are brought by changes in money-supply, by monetary-policy or fiscal-policy... A lose money-supply is likely to lower interest-rates, increase inflation and depreciation which could decrease imports and/or increase exports to reduce deficit, but decreasing imports might again deteriorate the external situation, demand for exports might also go down... Inflation and depreciation also cuts real-wages which would also reduce imports... It is contractionary... 

Friedman is talking about internal-devaluation to achieve external balance which is constrained by wage-rigidity and also by economic-policies, because the policy-makers would not let domestic employment and wages go down too much... But, borrowing cost could be brought down which would lower cost of production and prices... Interest-rate here could be a flexible price here, but depends upon inflation and inflation again depends on interest rate because it affects the supply-side... A low interest-rate and open economy regime might help improve the supply-side... Nevertheless, a higher inflation would increase interest-rate and a lower inflation would lower interest-rate... Therefore, low interest-rates because of low inflation or little deflation is likely to correct both internal and external demand... Low inflation would keep wages low; thereby increasing competitiveness... Lower cost of capital would also lower prices and make exports competitive...

Internal-devaluation or external devaluation to curb imports and increase exports, both reduce domestic-demand and increase the external demand... But, why a country chooses to increase external demand at the expense of the domestic demand? Which it should not do...

Of the both, internal devaluation seems more plausible because it helps reduce prices with downward-nominal-wage-rigidity and economic-policies to achieve full-employment, which might save domestic demand... Moreover, in external-devaluation, inflation and depreciation cut real wages to increase exports competitiveness which hurts domestic demand... In my view domestic demand should not be sacrificed for external-demand...

Domestic economy comes first...