Transaction Costs, Multiple Equilibria, and Currency Devaluation

Abstract

This paper attempts to examine the effect of a currency devaluation on domestic output by incorporating the Coase (1937) assertion into a standard open economy model. Our results show that there will be multiple equilibria in the labor market, i.e. low or high employment equilibrium, because of transaction cost externalities. If the labor market is in the high-employment equilibrium, a currency devaluation will depress domestic output. Conversely, a currency devaluation will enhance domestic output when the labor market is in the low-employment equilibrium. This conclusion provides an explanation for the mixed effect of the currency devaluation on domestic output in the empirical studies.