Revisiting the real exchange rate misalignment-economic growth nexus via the across-sector misallocation channel

Real effective exchange rate (REER) imbalances may affect economic growth by altering the allocation of labour and capital across sectors. This study assesses whether the component of inter-sectoral production factor misallocation induced by REER misalignments significantly hinders economic development and if this is the only channel via which REER imbalances operate. REER misalignments are derived from a Behavioural Equilibrium Exchange Rate model; labour misallocation and capital misallocation are measured, according to two alternative indicators, on a unique cross-country cross-sector national account dataset of 54 economies and 12 sectors over the years 1980-2015. Both REER over- and undervaluations lead to increased across-sector labour (but not capital) misallocation and, uniquely via this channel, they significantly hamper real growth. The correction of these external imbalances would thus stimulate inter-sectoral allocative efficiency and, ultimately, economic activity.