The Real Exchange Rate and Economic Growth

TLDR

The study proposes two explanatory categories for the effect of a high real exchange rate on growth: institutional weaknesses and product‑market failures. A formal model is employed to link the real exchange rate to economic growth. The analysis finds that a high real exchange rate stimulates growth, especially in developing countries, with the effect driven by the size of the tradable sector and robust across measures and methods.

Abstract

I show that undervaluation of the currency (a high real exchange rate) stimulates economic growth. This is true particularly for developing countries. This finding is robust to using different measures of the real exchange rate and different estimation techniques. I also provide some evidence that the operative channel is the size of the tradable sector (especially industry). These results suggest that tradables suffer disproportionately from the government or market failures that keep poor countries from converging toward countries with higher incomes. I present two categories of explanations for why this may be so, the first focusing on institutional weaknesses, and the second on product-market failures. A formal model elucidates the linkages between the real exchange rate and the rate of economic growth.