Implications of Real Exchange Rate Misalignment in Developing Countries: Theory, Empirical Evidence and Application to Growth Performance in Zimbabwe

Abstract

The influence of exchange rate signals in an economy is very powerful and often pervasive. Economists and policy makers thus strongly regard the real exchange rate (RER) as a key tool to influence the economy due to its role in determining production and consumption choices between domestic and international goods. Sustained RER overvaluation will eventually lead to drastic adjustments of relative prices and reduction of aggregate economic growth. In Zimbabwe, the recognition of this influence reinforced the widespread conviction that the extent of stability and ‘correct alignment’ of the RER played a dominant role in the post-ESAP economic crisis. This paper first presents a review of theoretical arguments and empirical evidence on the role of RER misalignment in developing countries. In addition, to investigate the relationship between growth and sustained RER overvaluation, the paper further applies a growth regression procedure that includes the misalignment index as an independent variable to Zimbabwe. After controlling for other growth determinants and structural factors, the empirical tests indicate that misalignment has a negative and statistically significant impact on growth in both the short and long run estimates.