Real Exchange Rate Behavior and Economic Performance in LDCs

Abstract

In recent years, policy discussions have included increasing references to real exchange rate (RER) stability and correct exchange rate alignment as crucial conditions to improve economic performance in less developed countries (LDCs).1 Evidence from Latin American, Asian, and African countries is often quoted to support the view that the link between RER behavior and economic performance is strong. It is argued that while unstable RERs inhibited export growth in some of Latin America, their stability was fundamental in promoting East Asian expansion. In many African countries, on the other hand, persistently misaligned local currencies harmed the development of agriculture, reducing domestic food supply.2 But, in spite of its importance, no empirical work has been attempted either to test the relationship between RER behavior and performance indicators at a broad multicountry level or to investigate the sources of RER variability and misalignment in LDCs. The theoretical literature on RER determinants has been recently surveyed by Sebastian Edwards.3 He distinguishes between equilibrium and disequilibrium RERs and between external and domestic RER determinants. Although domestic policies are often said to account for significant RER variations, empirical work has only concentrated on the effect of nominal devaluations4 or speculative crises arising from expansionary monetary policies in a system of fixed ex-