DEPARTMENT OF ECONOMICS Working Paper The Real Exchange Rate as an Instrument of Development Policy

Growth is endogenous in small open economies with substantial hidden or open unemployment, even under constant returns to scale. Growth promoting policies, however, have implications for the balance of trade, and two instruments are needed in order to achieve targets for both the growth rate and the balance of trade. The real exchange rate can serve as one of those instruments. Distributional conict imposes constraints on real exchange rate policies, but in LDCs the main exchange-rate related distributional conict may be over the sectoral distribution of pro ts, rather than the real wage. This paper develops a model along these lines and presents empirical support for the hypothesis that real exchange rate undervaluations are a useful instrument for the pursuit of accumulation and growth in low income countries. JEL classi cation: F43, O11, O41 Key words: Real exchange rates, underemployment, capital accumulation, investment, growth. An early version of this paper was presented at the Eastern Economic Association Meetings in New York, February 2009. We thank our discussant Jaime Ros for helpful comments and suggestions. yContact author: Department of Economics, University of Massachusetts Amherst, Amherst, MA 01003; email: arazmi@econs.umass. edu zDepartment of Economics, University of Massachusetts Amherst, Amherst, MA 01003; email: mrapetti@econs.umass. edu xDepartment of Economics, University of Massachusetts Amherst, Amherst, MA 01003; email: pskott@econs.umass. edu 1 Introduction Growth is endogenous in a dual economy without full employment, as evidenced for instance by the classic Harrod-Domar and Lewis models. This endogeneity of the growth rate also applies to open economies. In open economies, however, one needs to consider the implications of growth promoting policies for the balance of trade. Our basic argument is simple: two instruments are needed in order to achieve two targets (a growth rate and a balance of trade target). The real exchange rate can serve as one of those instruments. Most of contemporary economics assumes full employment, and those models that do include unemployment tend to play down the balance of payments constraint and the role of the real exchange rate in this regard. We disagree with both of these positions. Many developing economies have signi cant amounts of (hidden) unemployment, and a recent empirical literature suggests that the real exchange rate may have an important inuence on long term economic performance. The precise mechanisms behind this inuence, however, are unclear, and it is one of the aims of this paper to help ll that gap.1 We set up a stylized model of a small open economy. The economy has two sectors, both with constant returns to scale. A modern sector produces a tradable good while the output of a traditional sector is non-tradable. Only the former uses capital and all capital goods are imported. Assuming unemployment, we show that changes in the real exchange rate a¤ect the quantity and composition of employment and that the real exchange rate can be used to facilitate sustained capital accumulation. Real exchange rate policies of this kind have distributional e¤ects but in low income countries, we argue, the main exchange-rate related distributional conict may be over the sectoral distribution of pro ts. Our empirical section focuses on the role of real exchange rate undervaluations in promoting investment and output growth. We begin by replicating the results reported by Rodrik (2008). We nd that Rodriks conclusion pertaining to di¤erences between developing and developed countries in the growth e¤ect of real exchange rate misalignments is sensitive to how these groups are de ned in terms of income levels. We then create alternative classi cations and nd that, in general, real exchange rate misalignments do appear to have a more signi cant e¤ect on growth for developing countries. Our main empirical contribution, however, is to analyze the relationship between real exchange rate changes and investment in light of our theoretical framework. We show that real exchange rate undervaluations are (statistically) signi cant drivers of investment growth, but only in developing countries. This result is robust to di¤erent speci cations, controls, and econometric methods. The paper falls in eight sections. Section 2 surveys relevant literature while Section 3 provides some more context with the help of Chinese historical data. The benchmark model is presented in Section 4. We analyze the long-run implications of the model in Section 5 and consider the short run in Section 1According to Eichengreen (2007) the literature has invested more in documenting the growth rate-real exchange rate correlation than in identifying channels of inuence.