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Exchange rate devaluations hit poor households

International currency. (stock image)ANN ARBOR—As the value of a British pound fell under a euro this summer a year after the Brexit vote, tourists certainly took notice. But what about the poor?

Supporters of Brexit may not have considered the distributional impact of large swings in the pound. However, researchers at the University of Michigan have found that similar exchange rate devaluations have a greater negative impact on the poorer households than previously thought.

"The differential impact of large exchange rate changes on high- and low-income consumers is important for understanding the full consequences of large devaluations, and may be informative in shaping political support for policies such as Brexit," said Andrei Levchenko, a professor in the Department of Economics at U-M's College of Literature, Science, and the Arts.

And here's why: Poor households spend relatively more on tradeable product categories and consume lower-priced varieties within categories. So any changes in relative prices of these categories affect the cost of living of low-income relative to high-income households.

"It's been known for a very long time that the poor consume different baskets of goods than the rich. What was much less well-understood is that there is an interesting interaction between that and the exchange rate," Levchenko said. "In our data, the poor consume relatively more items that are internationally tradeable, compared to the higher-income households who consume relatively more non-tradeables such as education and personal services."

Levchenko and co-author Javier Cravino, an assistant professor of economics at U-M, studied economic data related to the 1994 devaluation of the Mexican peso. The paper describing the findings will appear in the November issue of the American Economic Review.

"Using household consumption patterns to examine the distributional impact of the devaluation of the peso during Mexico's 'Tequila Crisis,' we found that cost of living increases were 1.25 to 1.6 times higher for the poor compared to the rich," Cravino said.

They analyzed monthly price quotes on about 30,000 unique product-outlet level prices that the Bank of Mexico uses to construct the consumer price index, and household-level consumer expenditure surveys both immediately before and after the crisis.

Across product categories, low-income households spend relatively more on tradeables such as food, while high-income households spend relatively more on non-tradeables such as personal services. Within product categories, low-income households spend relatively more on lower-end goods purchased from lower-end retail outlets. Changes in the relative price of tradeables and of low-priced varieties following a large devaluation will thus affect households differently, generating a distributional welfare impact.

Looking within product categories such as breakfast cereal where it is assumed that the high-income households consume the more expensive varieties, and the low-income the less expensive ones, they found that inflation for the lower-income consumers was between 13 and 21 percentage points higher than for the higher-income consumers.

"Two things are universal... after a devaluation, prices don't all change by the same amount," Levchenko said. "To the extent that there are social safety nets, what they typically miss is that the poorer households consume different baskets than the high-income ones."

"Part of the decision-making process of leaving the European Union for Britain should be how it will affect different consumers. The effect can be very large. That has not been part of the thinking at all, but we argue it ought to be."

 

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