Political economy of real exchange rate levels

Abstract

Voluminous theoretical and empirical research shows that real exchange rate (RER) undervaluation could be conducive to economic development. Why do countries then often avoid the pursuit of policies that facilitate undervaluation or even intentionally pursue RER overvaluation? We address this question by investigating economic, institutional, and policy factors that help explain the within-country variation in RER undervaluation in a baseline panel of 68 developing and 39 developed countries between 1989–2013 using OLS and GMM estimators. Our results indicate that increases in the share of non-tradable sector output, imported input intensity of exports, and capital account openness is systematically associated with less undervalued RERs. We also provide evidence that independent central banks and democratic institutions are linked to RER overvaluation. Our key findings are robust to using alternative specifications, measures, estimation techniques, samples, and additional control variables. A preliminary comparison of Latin America and East Asia suggests interesting support for our key findings.