Devaluation and Competitiveness in a Small Open Economy - Ireland 1987-1993


Devaluation and Competitiveness in a Small Open Economy:
Ireland 1987-1993 by Leonardo Bartolini

This paper studies market expectations of a devaluation of the Irish
pound from 1987 to 1993 and relates them to the evolution of Ireland's
competitiveness over the same period. Changes in expectations of the
currency's devaluation can be explained largely by developments outside
Ireland, particularly by past and anticipated movements of sterling. The
evolution of Ireland's real exchange rate over the same period is also found
to be strongly linked to sterling's fluctuations, even after adjusting for
sterling-insensitive trade between Ireland and the United Kingdom and
despite the significant progress toward trade diversification recorded by
Ireland during the 1980s. The devaluation of the Irish pound in January
1993 is estimated to exceed investors' realignment expectations at that time
as well as the loss of Irish competitiveness since the beginning of the
exchange rate mechanism (ERM) crisis in the summer of 1992. This excess
devaluation helps explain subsequent large capital inflows and the Irish
pound's smooth transition to the wide ERM band in August 1993.