Floating capital

Abstract: This article is concerned with the determinants of economic growth, and, in particular, with the role of policy in directing the pattern of growth in developing economies. Over the years, economists and policymakers have focused primarily on fiscal and exchange rate policy. While the role of fiscal deficits is well understood, the same agreement does not hold with regard to exchange rate policy. Part of the reason for the controversial nature of exchange rate policy is that it comes in various styles--floating, dirty float, managed, dirty managed, pegged, and fixed. Besides floating, the success or failure of a particular exchange rate policy appears to be contingent not on the nature of the regime but rather on the direction of the misalignment of the currency. Bad exchange rate policy, in the form of an overvalued exchange rate, has been much analyzed and the results are well known. A persistently overvalued exchange rate leads to factor misallocations, loss in efficiency, higher inflation, and lower GDP growth. This conclusion is widely accepted, but the parallel theoretical and analytically equivalent conclusion--that exchange rate undervaluation is helpful to growth--is not. Moreover, even if accepted in theory, in practice the discussion gets involved with definitional and measurement issues. How do we define the real exchange rate? How does one measure it? Most important, how does one measure equilibrium? It is the latter that allows misalignment to be measured. Most of the empirical results to date do not support the conclusion that exchange rate undervaluation is helpful for growth. Easterly (2005) concludes, on the basis of an updated Dollar (1997) measure of currency undervaluation, that a policy of undervaluation does not matter as a determinant of economic development. Acemoglu et. al (2003) and the IMF (2005) reach the same conclusion, and find the impact to be even weaker if institutions are introduced into the growth model. Lately, however, some evidence of the positive growth effects of currency undervaluation is beginning to surface. In various articles (Bhalla 2002, 2005, 2008a, 2008b), I document this effect, as do Johnson, Ostry, and Subramaniam (2007, hereafter JOS) and Rodrik (2007). The plan of this article is as follows. In the next two sections, I discuss the definition of the real exchange rate and the different methods of measurement. I then examine the empirical basis for the notion that the "real exchange rate is endogenous (RERIE)." Phrased differently, the RERIE argument is the same as saying that the "impossible trinity" holds--namely, that it is impossible to simultaneously target the nominal exchange rate, have freely floating capital, and have an independent monetary policy. Next, I explain the mechanism through which exchange rate undervaluation is likely to work--by increasing the profitability of investment, leading to higher growth and savings and, therefore, to the operation of a virtuous cycle of investment-growth-savings. Empirical results are then presented for the effect of currency undervaluation (and overvaluation) in standard growth models. This section documents the large empirical role of two variables related to currency undervaluation: the valuation in the initial year, and the average change in undervaluation over the period examined. The latter variable is found to be particularly significant, and it helps explain the fast growth episodes of several economies. In the final section, I offer some policy conclusions. The Real Exchange Rate: Definition and Measurement There are two closely related definitions of the red exchange rate (RER). The two definitions represent the external sector (primary definition) and the internal sector (secondary definition). The "external" definition of the RER is the ratio of the overall price levels between two economics, (1) while the "internal" definition is the domestic economy ratio of the price of nontradable goods ([P. …