Why Does the Real Exchange Rate Matter for Economic Development?

Abstract

A recent body of empirical work suggests the existence of a positive association between real exchange rate (RER) levels and economic growth, especially in developing countries. This relationship appears to be driven by cases of overvaluation hurting growth and undervaluation favoring growth. The literature has proposed different mechanisms to explain the observed behaviors. One of them emphasizes that higher and more stable RERs reduce macroeconomic volatility favoring capital accumulation and growth. Another one stresses that higher and more stable RERs stimulate capital accumulation in modern tradable activities, facilitating structural change and economic development. This paper supports the view that developing countries could target stable and competitive real exchange rate (SCRER) as a part of a development strategy that promotes the expansion of modern tradable activities. It reviews the empirical findings, discusses the channels through which a SCRER can stimulate economic growth, and describes the policies needed to pursue a development strategy based on a SCRER.