Exchange rate misalignments, growth, and institutions

Abstract

This article revisits the relationship between economic growth and exchange rate misalignments. We aim to test whether undervaluation's impact on growth depends on institutional quality, as suggested in the previous literature. In our analysis, we focus on recent decades characterized by globalization. We use the framework of cross-country growth regressions estimated using the recently developed two-stage instrumental variable method, which allows accounting for cross sectional dependence. In addition, we use external instruments to address the potential endogeneity between economic growth and undervaluation. Our results confirm the positive relationship between undervaluation and growth across all income groups from low-income to high-income countries. The role of institutions in the transmission of undervaluation on growth appears consistently only among lower-middle-income countries. Therefore, while our results point to the positive effects of undervaluation, the support for the hope that countries can successfully compensate for poor institutional quality via the undervaluation of currencies is weaker and limited to specific stages of economic development.