The Effect of Currency Misalignment on Income Inequality

This paper examines the relationship between currency misalignment and income inequality across 70 countries from 1998 to 2021. Currency misalignment occurs when the actual exchange rate diverges significantly from the equilibrium exchange rate. Using fixed-effects and random-effects regressions, we find that currency overvaluation is associated with higher income inequality, while undervaluation is linked to lower income inequality. These findings are strongest in emerging markets and upper-middle-income countries, where undervalued currencies may be associated with stronger tradable-sector activity and narrower income gaps. In contrast, lower-income countries experience increasing levels of inequality during the early stages of development, even with growth, which is consistent with the Kuznets hypothesis. For advanced markets and higher-income nations, currency misalignment is not statistically related to income inequality, which is likely due to the presence of stronger financial systems and more stable institutions that reduce the effects of currency misalignment. The results are robust across the two grouping methods—development level (IMF) and income level (World Bank). Overall, the study highlights that while undervaluation may be associated with equitable growth in emerging markets, its benefits likely depend on a country’s development stage and are more likely when accompanied by appropriate social and economic policies to mitigate potential risks.