Real Exchange Rates and Growth: Contractionary Depreciations or Appreciations?

This study investigates the impact of real exchange rates (RER) on growth of a large number of advanced (AE) and developing economies (DE) estimating conventional growth models augmented with global financial conditions variables. First of all, replicating Rodrik (2008) and following studies employing panel autoregressive distributed lag (PARDL) and PARDL mean group (PARDL-MG) models, we show that the expansionary depreciation findings for DE are often based on a misinterpretation of an error correction mechanism coefficient. Then, we investigate the relationship between RER and growth explicitly taking into account balance sheet or external debt vulnerabilities which often do not considered by conventional growth literature. Fully-Modified OLS estimation results show that, the external variables demonstrating global financial and monetary conditions are strongly significant in explaining growth in DE along with the conventional domestic variables including trade openness, human capital and savings. Furthermore, our results suggest that, RER depreciations are contractionary for DE with high external debt and expansionary for AE. However, higher trade openness decreases the contractionary impact of depreciations in both AE and DE. These results are robust for different RER and real income measures.