Does Real Exchange Rate Depreciation Boost Capital Accumulation? An Intertemporal Analysis

Abstract

This paper examines the investment‐enhancing effect of real exchange rate (RER) depreciation in a two‐sector small open economy model where a representative firm in the tradable sector maximises its discounted profit over an infinite planning period. In this framework, a one‐time, permanent, unanticipated depreciation in the RER leads to a higher steady‐state level of capital stock and investment. This consequently increases the optimal investment rate associated with an arbitrary level of capital stock as the saddle path shifts upwards. In the benchmark calibration, the investment‐enhancing effect of RER depreciation is sizeable. One per cent depreciation in the RER leads to an increase of 0.4444 per cent in the rate of capital accumulation.