January 23, 2022
  • January 23, 2022

The role of exchange rates in economic development

By on June 22, 2021 0

The impact of exchange rate policy on economic development remains a hotly debated subject. In the macroeconomic literature on developing economies, two important concerns are raised about exchange rate policies: the links between exchange rates, the balance of payments, and macroeconomic stability and growth. The importance of a competitive and stable exchange rate, which plays out in economic diversification, is major. Expansion towards activities with increased technical content, in this perspective, is the key to future growth, which can be facilitated by an appropriate exchange rate policy.

The experiences of East Asia, especially those of newly industrialized countries and, more recently, China are presented as successful examples of diversification. This contrasts with the difficulty that many natural resource-dependent economies diversify in their production and export patterns, which can be attributed in part to the appreciation of the exchange rate as a result, as well as to premature adoption of new technologies. The importance of exchange rate policy, especially in open economies, is crucial.

Economic development and real exchange rate policies

It is also argued that in the presence of spillovers from apprenticeship in some different sectors, the inability to directly subsidize these sectors, either because of serious economic problems, including the risks associated with rent seeking, which hamper a efficient allocation of grants or due to regulations that hamper the implementation of grants. The best use of existing policy instruments results in a separate RER for sectors with varying spillovers while respecting the official commitment of IMF members to avoid multiple exchange rates.

Any strategy that has the capacity to reallocate the factors of production of the economy towards sectors with high impact on learning has the potential to improve well-being. The first best policy response is to provide transfers and subsidies to these sectors. However, if these policies are not sustainable, RER policies could play an important role as a stopgap option.

Not only is the level of the exchange rate crucial, but so is its stability. This is particularly relevant in poorer countries, where hedging exchange rate fluctuations is impractical or prohibitively expensive, and where capital markets have other flaws. The stability of the real exchange rate is essential to reduce the risks of new investments in the trade sector. A final caveat concerns the international ramifications of the measures. Implementing an active exchange rate strategy can have negative externalities for other countries, especially if the country adopting the strategy is a major player in world trade.

In the case of the forex market, when traders are involved in the daily exchange, this is when the difference between currencies matters the most. During the global pandemic, many people were involved in the market in the hope of making financial profits, and because all currencies fluctuated during this time, the risks of inefficient trading were really high. However, this did not stop newbies from entering the new industry, as brokerage firms suggested profitable opportunities, such as starting to trade with no money or getting a discount if a friend signed up. Thus, international transactions were always in active mode and exchange rates also played a crucial role in this case.

Instruments for competitive exchange rates

Regulations on capital accounts and interventions in foreign exchange markets could be used to maintain the competitiveness of the RER. Capital account rules that include all regulations affecting private sector access to foreign capital can have a long-term impact on the RER. They can be supplemented in various ways by intervention strategies on the foreign exchange market and in particular the constitution of foreign exchange reserves. China’s experience demonstrates the mechanism at work. China’s tradable goods industry grew rapidly between 2002 and 2008. In the absence of government action, the renminbi would have appreciated it. However, appreciation forces were resisted by capital account rules and huge stocks of foreign exchange reserves.

Many governments prefer to place more emphasis on interventions in the currency market rather than on capital account laws. Such interventions have become commonplace in many emerging and developing countries, particularly after the 1997 crisis in developing countries in East Asia.

Overall, the data show that supplementing the use of traditional macroeconomic policies with interventions in foreign exchange markets and capital account rules is the best way in developing countries economically vulnerable to boom-bust cycles. external financing. Recent research has shown that these actions are successful in stabilizing the macroeconomics and promoting growth, contradicting previous studies from the 1980s which mainly rejected their usefulness.

Final thought

Finally, in summary, stable and competitive real exchange rate policies are favorable to economic development, according to several historical examples. It is suggested that this attitude as the ultimate political strategy in the presence of specific limits on the set of policy tools available has a solid theoretical basis. The major argument against such interventions – that they interfere with the free functioning of the brand, which would ensure effectiveness in the absence of such intervention, overlooks two key points:

The intervention of central banks, whether fixing interest rates or not, has an impact on the value of the exchange rate. This directly means that the term such as pure market exchange rate does not exist in the economy. All economies, whether developed like the United States and Switzerland or emerging economies, are riddled with market imperfections, such as macroeconomic externalities and learning. A review of the empirical evidence on assessing the effectiveness of various policy instruments, highlights that foreign exchange interventions and capital account regulation can be effective in maintaining competitive exchange rates and hence promoting stability. and growth.

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