The welfare effects of a large depreciation

A working paper about Egypt from WB-The welfare effects of a large depreciation : the case of Egypt, 2000-05 by Art Kray;

Summary: The Egyptian pound depreciated sharply between 2000 and 2005, declining by 26 percent in nominal trade-weighted terms. The author investigates the effect of the large depreciation on household welfare operating through exchange rate-induced changes in consumer prices. He estimates exchange rate pass-through regressions using disaggregated monthly consumer price indices to isolate the impact of the exchange rate changes on consumer prices. Then he uses household-level data from the 2000 and 2005 Egyptian household surveys to quantify the welfare effects of these consumer price changes at the household level. The average welfare loss due to exchange rate-induced price increases was equivalent to 7.4 percent of initial expenditure. Stronger estimated exchange rate pass-through for food items imply that this effect disproportionately affected poorer households

Some caveats;

One should however keep in mind three major caveats about these results. The first is that I have looked only at the effects of the exchange rate working through consumer prices. The depreciation is also likely to have had heterogenous impacts on the earnings of households employed in different sectors, and these effects are not capture for lack of (a) detailed information in the household survey of the sector of employment of households, and (b) evidence on the effects of exchange rate changes on wages across sectors in Egypt.

A second limitation is that data limitations have also forced me to work at a fairly high level of aggregation. At this coarse level of aggregation, estimated substitution effects in response to price changes are small, and so I am likely to be overestimating the effects on household welfare. Consider for example the study of the Indonesian depreciation of 1997 by Friedman and Levinsohn (2002). They worked with a much more highly disaggregated set of expenditure items, and found that substitution effects were roughly half the size of the direct effects. If similar substitution behavior occurred for households in Egypt in response to the (much smaller) set of price changes, but was missed at the coarse level of aggregation at which I have worked, then the adverse welfare effects of the depreciation will be considerably overstated and could be much smaller.

Finally, as noted in the introduction, I have studied the welfare effects of depreciation-induced changes in consumer prices over a fairly short period with a fairly large depreciation, and this time horizon drives the finding of significant welfare losses. It is important to note that the depreciation in the trade-weighted nominal exchange rate between 2000 and 2005 was preceded by an even larger trade-weighted nominal appreciation in the previous five years between 1995 and 2000, and that over the entire period between 1995 and 2005, the trade-weighted nominal exchange rate appreciated by about 20 percent. If the pattern of exchange rate pass-through to disaggregated consumer prices was similar during this earlier period, then one can interpret the welfare losses sustained between 2000 and 2005 as just a partial reversal of the welfare gains experienced during the appreciation between 1995 and 2000.