This paper addresses these issues and contributes to the existing limited literature along several dimensions. First, it discusses the different channels through which remittances can affect the real exchange rate using a framework where the equilibrium exchange rate is characterized by an external equilibrium similar to those analyzed in asset market models (Mussa, 1984 and Frenkel and Mussa, 1985) and an internal equilibrium based on a productivity differential model as those in Balassa (1964) and Samuelson (1964).

Second, it provides estimates of the impact of remittance flows on the real exchange rate using a large cross national data set rather than information for a limited number of countries. Our approach allows testing whether there are regional differences and more specifically whether Latin America is different in this context. Note that one of the main differences between the work of Amuedo-Dorantes and Pozo (2004) and Rajan and Subramanian (2005) is the coverage of the data. Thus if the impact of remittances on the real exchange rate is different in Latin American than in the rest of the world, then the different findings of Amuedo-Dorantes and Pozo (2004) and Rajan and Subramanian (2005) should not be surprising. In fact, to anticipate some of the results in Section IV, this paper argues that remittances flows appear to affect the real exchange rate at a global level and that Latin American countries do not appear to be an exception. These results are robust to the presence of fixed effects in the data, potential reverse causality from the exchange rate to remittances, and variations in the set of control variables.

Third, the paper also explores the extent to which the estimated appreciation in Latin America is consistent with the change in economic fundamentals implied by the increase in remittances or instead whether it can be attributed to changes in the misalignment component of the real exchange rate (i.e. changes in the underlying real over/undervaluation of the currency). To also anticipate our results on this, we find that the evolution of the Latin American real exchange seems to be driven by a combination of changes in the equilibrium real exchange rate and changes in the degree of misalignment.

Finally, on the basis of its empirical results the paper discusses a number of options for policy makers concerned with the impact that a surge in remittances may have on the external competitiveness of the country. In particular, we discuss the possibility that a revenue-neutral policy of a partial switch from direct to indirect taxation may reduce labor costs and thus (at least to a degree) sterilize the negative labor supply effect as well as the real exchange rate appreciation due to rising remittances —an encouraging outcome for countries under budget constraint pressure. The rest of the paper is organized as follows. In Section II we consider an additional number of theoretical considerations that may explain why remittances may lead to a real exchange rate appreciation and review the evolution of remittances, the real exchange rate, exports and imports for the 8 largest receivers of remittances (as a percentage of GDP) in Latin America. Section III reviews the empirical strategy used to assess the impact of remittances on the real exchange rate. In Section IV, we present the results of estimating two econometric models. One relates changes in the real effective exchange rate to the ratio of remittances to GDP. The second uses as explanatory variable the changes in a measure of real exchange rate overvaluation. The basic idea here is trying to disentangle how much of the observed changes in the real exchange rate are due to changes in the equilibrium exchange rate and hence consistent with the evolution of economic fundamentals. Section V discusses whether one specific policy option (shifting the tax structure from direct towards indirect taxation) can contribute to 5