Recent empirical studies have found a robust correlation between competitive exchange rates and economic growth in developing economies. This paper presents (i) a formal model to help explain these findings and (ii) econometric evidence on the relation between investment and the real exchange rate. The model emphasizes the existence of (hidden) unemployment as a source of endogenous growth, even under constant returns to scale. Growth promoting policies, however, affect the external balance, and two instruments are needed in order to achieve targets for both the growth rate and the trade balance. The real exchange rate can serve as one of those instruments. The implications of the model for the relation between real exchange rates and the rate of capital accumulation find support in our econometric analysis.JEL classification: F43, O11, O41

Recent research has found a positive relationship between real exchange rate (RER) undervaluation and economic growth. Different rationales for this association have been offered, but they all imply that the mechanisms involved should be stronger in developing countries. Rodrik (2008) explicitly analyzed and found evidence that the RER-growth relationship is more prevalent in developing countries. We show that his finding is very sensitive to the criterion used to divide the sample between developed and developing countries. We then use alternative classification criteria and empirical strategies to evaluate the existence of asymmetries between groups of countries and find that the effect of currency undervaluation on growth is indeed larger and more robust for developing economies. However, the relationship between RER undervaluation and per capita GDP is non-monotonic.

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.

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