Neoclassical price theory, and its extension to IMF country advice, argues that balance-of-payments crises such as Pakistan’s are better resolved by depreciating the exchange rate, making exports cheaper and imports dearer. We argue that a partial equilibrium analysis of just the tradeable goods market on the current account side ignores the capital market on the capital account side, where an increase in outflows allows no equilibrium value for the exchange rate, through a phenomenon dubbed ‘depreciationary expectations’, akin to inflationary expectations. Thisphenomenon will not allow the exchange rate to settle at an equilibrium level, leading to a vicious downward cycle. In such a case,capital controls may well be needed to counter the downward cycle, allowing a return to growth.
Pakistan’s Balance-of-Payments Crisis and Some Policy Options
