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Output and the real exchange rate in developing countries: an application to Mexico

  • Steven B. Kamin
  • John H. Rogers

Since Mexico's devaluation of the peso in 1994, some observers have called for policies designed to keep the real exchange rate highly competitive in order to promote exports and output growth. However, over the past few decades, devaluations of the real exchange rate have been associated nearly exclusively with economic contraction, while real appreciations have been followed almost invariably by expansions in economic activity. The purpose of this paper is to attempt to disentangle the possible factors underlying this correlation--(1) reverse causation from output to the real exchange rate, (2) spurious correlation with third factors such as capital account shocks, and (3) temporary contractionary effects of devaluation--and determine whether, once those factors are accounted for, a positive, long-run effect of real depreciation on output can be identified in the data. Based on the results of a VAR model designed to explore the linkages between the real exchange rate and output, we conclude that even after sources of spurious correlation and reverse causation are controlled for, real devaluation has led to high inflation and economic contraction in Mexico. While changes in Mexico's economic structure and financial situation may qualify the future applicability of this conclusion, we view our findings as pointing to substantial risks to targeting the exchange rate at too competitive a level.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 580.

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Date of creation: 1997
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Handle: RePEc:fip:fedgif:580
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  1. Rebelo, Sérgio, 1997. "What Happens When Countries Peg Their Exchange Rates? (The Real Side of Monetary Reforms)," CEPR Discussion Papers 1692, C.E.P.R. Discussion Papers.
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  8. Kamin, Steven B. & Rogers, John H., 1996. "Monetary policy in the end-game to exchange-rate based stabilizations: the case of Mexico," Journal of International Economics, Elsevier, vol. 41(3-4), pages 285-307, November.
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  18. Steven B. Kamin & John H. Rogers, 1997. "Output and the real exchange rate in developing countries: an application to Mexico," International Finance Discussion Papers 580, Board of Governors of the Federal Reserve System (U.S.).
  19. Kiguel, Miguel A & Liviatan, Nissan, 1992. "The Business Cycle Associated.with Exchange Rate-Based Stabilizations," World Bank Economic Review, World Bank Group, vol. 6(2), pages 279-305, May.
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  21. Ben S. Bernanke, 1986. "Alternative Explanations of the Money-Income Correlation," NBER Working Papers 1842, National Bureau of Economic Research, Inc.
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  24. Rudger Dornbusch & Ilan Goldfajn & Rodrigo O. Valdés, 1995. "Currency Crises and Collapses," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 26(2), pages 219-294.
  25. Ben S. Bernanke & Mark Gertler, 1995. "Inside the Black Box: The Credit Channel of Monetary Policy Transmission," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 27-48, Fall.
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