The Real Income Channel and Contractionary Devaluations in a Heterogeneous Agent Model for Latin America

SSRN

Joint with Rodolfo Campos

Abstract:
In conventional macroeconomic theory, exchange rate depreciations are expected to boost net external demand and overall output. However, in many emerging economies—including those in Latin America—devaluations can have contractionary effects. This article uses a heterogeneous agent open-economy model to study a mechanism known as the real income channel, which operates through the erosion of purchasing power caused by higher import prices. The model is calibrated for several Latin American economies and quantifies the size of this channel relative to the traditional expenditure-switching effect. The findings suggest that countries with higher trade openness experience stronger contractionary effects due to the real income channel. Policy implications include the relevance of financial inclusion in mitigating these adverse effects.

JEL Codes: F41, F31, E37. Keywords: real income channel, devaluations, heterogeneous agents, Latin America.