An empirical and theoretical analysis of real exchange rate targeting in developing countries

Niloufer Sohrabji, Boston College

Abstract

This work is a study devaluation policy in developing countries with fixed exchange rate regimes. If the actual exchange rate is set below the equilibrium exchange rate, the currency is overvalued. An overvalued nominal exchange rate results in an overvalued real exchange rate. This results in a "small" traded goods sector which ultimately may be reflected in unsustainable trade deficits. Devaluation is expected to increase the actual exchange rate to its equilibrium level and thereby result in a real exchange rate depreciation. A real exchange rate depreciation is expected to stimulate investment into the traded goods sector and improve the trade deficit. However, despite repeated nominal devaluations, overvaluation in the real exchange rate and unsustainable trade deficits continue to persist. This dissertation makes the claim that contradictory policy-making is the reason for this failure. I study this problem both empirically and theoretically separately in two chapters. The first chapter is an empirical paper. From a sample panel data set of developing countries with fixed exchange rate regimes, I study the impact of policy on real exchange rate overvaluation. The policies are devaluation, monetary and fiscal policy. It is generally believed that conflicts in policy-making dilute the effect of each of the policies, but devaluation ultimately corrects real exchange rate overvaluation. The evidence from this paper suggests that conflicting monetary and fiscal policy may reverse the effect of a devaluation. In the second chapter I study the reason for this contradiction in policy-making. I make the claim that lack of credibility is the reason for this contradiction. To support this claim I use a simple model to study the effect of devaluation policy on the economy. Devaluation is expected to generate investment into the traded goods sector. If the policy is not perfectly However, agents do not invest in the traded sector. Now the government has a reason to reverse the policy. Therefore lack of credibility discourages investment, which results in the reversal of the policy i.e. it is a self-fulfilling prophecy.

Recommended Citation

Niloufer Sohrabji, "An empirical and theoretical analysis of real exchange rate targeting in developing countries" (January 1, 2000). Boston College Dissertations and Theses. Paper AAI9995943.
http://escholarship.bc.edu/dissertations/AAI9995943