Real Exchange Rate Misalignment and Economic Growth : An Update

This paper empirically examines the relationship between real exchange rate misalignment and economic growth by using an updated data set over the sample period 1990-2014 for a large number of countries. Our findings indicate that the measure of real exchange rate misalignment is positively associated with economic growth for the low and middle-income countries whereas no significant relationship between these two for richer countries, implying the more overvalued the currency is over the long run, the lower the long-run growth rate of per capita income in developing countries. A plausible interpretation of this finding is that following the financial liberalization, large capital inflows and lending boom lead to appreciation of real exchange rates in the majority of developing countries. Prolonged real appreciation may result in lower long-run growth because of two channels: first, by changing resource allocation in favour of nontraded-goods sector it may reduce the long-term growth prospects; and second, by promoting private debt denominated in foreign currency it makes economy more vulnerable to external shocks, that is due to contractionary balance-sheet effects, a sudden and sharp real depreciation, which often happens in the boost cycle, may have a negative effect on output and growth.