The Effect of Real Exchange Rate Undervaluation on Economic Growth

Over the years, economists have come to agree that a poorly handled exchange rate would do more harm than good to the growth efforts of any economy. However, the exact relationship between the exchange rates and the economic growth is not well understood. This study uses Rodrik (2008) paper on “the real exchange rate and economic growth” as a benchmark work to carry out a comprehensive analysis of the impact of currency undervaluation on economic growth. To this end this thesis is organized into four independent studies. The first two are panel data studies where the economic growth is regressed on real exchange rate undervaluation. The two studies differ from each other mainly in two ways. One difference is the way that currency undervaluation is measured, and the second difference is the way the growth equation is modelled. In short, second study-which is referred as fundamental equilibrium exchange rate model- is intended to be an improvement on the first study –which is referred as the Balassa-Samuelson effect based Rodrik approach. The third research examines how the real exchange rate undervaluation impacts economic growth by using time series analysis. The relationship studies for four countries, -namely Germany, South Africa, Mexico, and Cameroon- with different exchange rate regimes. The studies check if the relationships are symmetric or asymmetric; and accordingly uses ARDL or NARDL methodologies to investigate how the real exchange rate undervaluation impacts growth. The fourth study looks at the contribution of the real exchange rate undervaluation, the tourism sector, and human capital development to the economic growth by using a panel data of selected microstates – many of which are small island nations-. In all four studies, the results are mainly in line with the theoretical expectations and/or with main previous empirical works. Our results provide evidence that real exchange rate undervaluation mainly has a positive impact on growth. Keywords: Economic growth, Exchange rate, Balassa-Samuelson effect, asymmetric relation, Tourism, human capital.