Devaluations and Growth: The Role of Financial Development

In this paper we rationalize the observation that in emerging markets an exchange rate devaluation might have a negative effect on production, due to the fact that the increase in the value of liabilities denominated in foreign currency causes a tightening in the domestic financial conditions, potentially offsetting the effect of an increase in the value of exports. We build on cite {Melitz2003} to propose a model with heterogeneous firms in a small open economy where firms face financial frictions when borrowing from abroad. Depending on how strong the friction is, a foreign shock that results in an exchange rate devaluation might translate into lower output, even if exports increase.

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