Macroeconomic Policy Coordination in a Competitive Real Exchange Rate Strategy for Development

Abstract

Recent research has documented a positive relationship between real exchange rate (RER) levels and economic growth. The literature has interpreted this correlation as causality running from RER levels to growth rates; i.e., higher, undervalued, more competitive RERs tend to favor growth. Little effort has been made, however, on the analysis of the policy instruments required to implement a successful competitive RER strategy. An exchange rate policy targeting a permanent change in the RER may run into difficulties: it is well documented that nominal and real exchange rate movements are correlated almost one for one in the short run but such co-movement slowly vanishes in the long run. Targeting instead a transitory RER undervaluation can have long-lasting effects on economic performance if RER competitiveness is stable and durable enough to provide incentives for tradable activities to expand. The ability to provide such an environment may be beyond the scope of exchange rate policy. This paper aims to shed light on the complementary policies that facilitate the success of an exchange rate policy that temporarily increases competitiveness. A formal model inspired by Ros and Skott (1998) is developed to analyze these issues. The main conclusion is that an exchange rate depreciation would more likely trigger an acceleration of growth if it is simultaneously implemented with domestic demand management policies that prevent non-tradables price inflation and wage management policies that coordinate wage increases with tradable productivity growth.

12. The Real Exchange Rate and Economic Growth: Some Observations on the Possible Channels

“…Similarly, temporary RER overvaluation can lead to de-industrialization and lower growth -as in the Dutch disease case-when tradable firms' production is subject to some form of increasing returns to scale (e.g., Krugman, 1987, andRos andSkott, 1998). The opposite case -transitory RER undervaluation-can spur a virtuous dynamics of structural change and economic development (Rapetti, 2013). Models of export-led growth have emphasized positive externalities that are not equally prevalent in nonexport activities; policies reallocating resources to export industries therefore promote higher growth in these models (e.g.…”

Competitive exchange rate and infrastructure in a macrodynamic of economic growth

“…The second condition, similarly to the model in Rapetti (2013), is more likely to hold the higher the values of , and , i.e., the more capital intensive is the tradable production, the more elastic the supply of non-tradables and the higher the share of tradables in private consumption. Our following analysis will assume that both conditions hold.…”

“…Rapetti (2013) shows how the implementation of domestic demand policies, including the reduction of government spending, can be important to accomplish a successful exchange rate policy. The right balance between types of expenditure must be found, opting for the reduction in non-productive expenditure.…”

“…Rapetti (2013) uses a dual economy model to explore how aggregate demand and its effect on inflation can block the growth response of an exchange rate policy. Especial attention is given to the inflationary pressures emanating from non-tradable goods and wages, which may prevent the tradable sector from developing faster.…”

“…The author concludes that policies' coordination, especially on domestic demand and wage growth, makes the strategy of pursuing a competitive exchange rate more viable. While Rapetti (2013) -from which the model set forth in this dissertation draws a great dealfocuses on the importance of conducting an exchange rate policy along with aggregate demand policies, we aim to explore some channels through which supply policies can facilitate the success of a competitive exchange rate policy.…”