The real consequences of policy-driven exchange rate cycles: A stylized comparison of East Asia and Latin America

Abstract

I develop the implications for capital accumulation, the trade balance, and real exchange rate cycles of different policy preferences, focusing in particular on broad stylized features of major Latin American and East Asian economies. Recent development literature has renewed interest in real exchange rate policy and the desirability of avoiding overvaluations. Political science literature, on the other hand, has emphasized the role of factors such as the influence of the manufacturing sector and the nature of the work force in shaping exchange rate policy. I formalize and relate some of these insights in a simple, dynamic, developing country framework with policy makers who intertemporally optimize and voters/audiences that are myopic. Given the choice between assigning greater weight to: (1) raising immediate worker purchasing power or (2) generating wage increases and manufacturing employment over time, I show that developing countries where policy makers choose the former are more likely to experience cycles with overvaluation, trade deficits, and abrupt (postponed) devaluations. Moreover, these cyclical differences may help explain differences in structural evolution over longer periods of time.