The real exchange rate and economic growth: Revisiting the case using external instruments

Abstract

The real exchange rate and economic growth: revisiting the case using external instruments ECB Working Paper, No. 1921 Provided in Cooperation with: European Central Bank (ECB)Suggested Citation: Habib, Maurizio Michael; Mileva, Elitza; Stracca, Livio (2016) : The real exchange rate and economic growth: revisiting the case using external instruments, ECB Working Paper, No. 1921, ISBN 978-92-899-2169 www.econstor.eu Working Paper SeriesThe real exchange rate and economic growth: revisiting the case using external instruments AbstractWe investigate the impact of movements in the real exchange rate on economic growth based on …ve-year average data for a panel of over 150 countries in the post Bretton Woods period. Unlike previous literature, we use external instruments to deal with possible reverse causality from growth to the real exchange rate. Our country-speci…c instruments are (i) global capital ‡ows interacted with individual countries' …nancial openness and (ii) the growth rate of o¢ cial reserves. We …nd that a real appreciation (depreciation) reduces (raises) signi…cantly annual real GDP growth, more than in previous estimates in the literature. However, our results con…rm this e¤ect only for developing countries and for pegs. Non-technical summaryThis paper takes another look at the effect of the real exchange rate on economic growth per capita from a medium term perspective, which is a question still unsettled in the literature following previous work by Rodrik (2008) and others. Its main contribution to the literature is in the identification strategy based on instrumental variables (IV). We aim at identifying exogenous movements in the real exchange rate, notably movements that are not driven by country-specific growth shocks, such as productivity shocks. We estimate the effect of real exchange rate movements on growth on a large panel of close to 150 countries over a sample of five-year periods from 1970 to 2010.The paper uncovers three main results:• Our identification strategy finds a strong and statistically significant positive (negative) effect of real depreciation (appreciation) on real per capita growth over five-year average periods. The effect is visible in developing countries and pegs, and is not significant or wrongly signed in advanced countries and floats.• The effects appear to be approximately symmetric between appreciations and depreciations, although large depreciations appear to have a stronger impact than large appreciations on average.• The effects that we estimate through the IV approach are much larger than previous comparable results in the literature.Our overall conclusion is that the real exchange rate does matter for growth in developing economies, but substantially less so in advanced ones, which confirms and strengthens the conclusions of Rodrik (2008).It should also be pointed out that our results suggest that using the exchange rate as a policy lever could be beneficial only in the early stages of economic development, while it becomes irrelevant in the long term...

Drivers of the real effective exchange rates in high and upper‐middle income countries

“…The results in Table which include a sample of 60 high‐income and upper‐middle income economies indicate a strong positive relationship between economic growth and the REER which is broadly aligned with the empirical literature (Habib et al, ). The pairwise Granger causality tests as shown in Table serve as robustness checks for our GMM estimations.…”

“…Typically the empirical studies explore the effect of REER on economic growth. As Habib, Mileva, and Stracca () note, the issue of reverse causality between the exchange rate and growth is usually tackled with the use of GMM.…”

Real exchange rate appreciation after the financial crisis of 2008–2009: Misalignment or fundamental correction?

“…The negative impact of overvaluations is expected to be larger in developing countries where market failures are more severe and where income inequality is larger, when compared to developed countries. In fact, in a recent contribution, Habib, Mileva, and Stracca () identify a strong and statistically significant negative effect of real appreciation on real per capita growth over 5‐year average periods. The effect is stronger for developing economies and in countries pegging their currency, while it is not significant in advanced economies and those floating their currency.…”

Asset Prices and Macroeconomic Outcomes: A Survey

“…Others, such as Harchaoui et al (2005), find ambiguous results of exchange rate volatility on investment, which is consistent with theoretical models. Habib et al (2017) find that a real appreciation (depreciation) is associated with significantly lower (higher) GDP growth but only for developing and currencypegging countries.…”