The Distributional Consequences of Exchange Rate Devaluations

We study the differential impact of large exchange rate devaluations on the cost of living at different points on the income distribution. Across product categories, the poor have relatively high expenditure shares in tradeables. Within tradeable product categories, the poor consume lower-priced varieties that contain relatively less domestic value added. A devaluation raises the relative price of tradeables, and within product categories raises the relative price of cheaper varieties. Both effects imply that the devaluation hurts the low-income households more than the high-income ones. We quantify these effects following the 1994 Mexican peso devaluation and show that the distributional consequences can be large. Following the devaluation, the cost of the consumption basket of those in the bottom decile of the income distribution rose between 1/3 and 1/2 times more than the cost of the consumption basket for the top income decile. We supplement the detailed results for Mexico using cross-country evidence.