Exchange rates and the speed of economic recovery: The role of financial development

Abstract

We study the influence of the exchange rate on the speed of economic recovery in a sample of 67 developed and developing economies over the years 1989–2019. First, using a cross-sectional sample of 341 economic recoveries, we study the effect of nominal depreciation and real undervaluation on the length of economic recovery. Our findings indicate that a small nominal depreciation, as well as a real undervaluation of the domestic currency, increases the speed of economic recovery. However, this effect is small in size. Second, we use an interacted panel VAR (IPVAR) model to investigate the effect of real undervaluation on the speed of economic recovery after an external shock. While we once again find evidence that an undervalued domestic currency increases the speed of economic recovery, its positive effect is limited in size. Furthermore, we also explore the role of financial development in influencing the effectiveness of an undervalued domestic currency in stimulating economic recovery. We find that a higher level of financial development limits the negative effect of an overvalued currency on the speed of economic recovery, but does not influence the effect of an undervalued currency on economic recovery.