Gabriel Porcile (ECLAC)
Figure 1. RER and Specialization
The literature suggests that production structures that are more complex (in the sense that they are more diversified and more knowledge-intensive) perform better in various dimensions—growth, international trade, real wages. In turn, the complexity of the production structure is related to the adoption of industrial and technological policy (see also our post Does production structure matter for income distribution?). Such policies are an important part of the catching up story, but other variables also play a role. An increase in the real exchange rate may allow the developing economy to compensate for lower relative productivity and hence encourage new exports.
This is a point raised by several works (classical works are Baldwin, 1988 and Baldwin and Krugman, 1989; see also McMillan and Rodrik, 2010), which we tested recently in a cross-country analysis (Cimoli, Fleitas and Porcile, 2013). We found that a higher RER is consistently associated with higher diversification and a higher technological intensity of exports. A simple graph helps to understand why. In figure 1, the y-axis represents the real exchange rate and the x-axis represents the number of goods produced in the economy, ranked in terms of a growing productivity gap (productivity in the developed country / productivity in the developing country). A higher z means a higher productivity gap. For a given productivity curve, an increase in the RER allows the economy to produce more goods (from z1 to z2).
However, it is not without risks betting just on the RER for competitiveness. A high RER depresses real wages. To avoid a negative impact on workers’ welfare, it is necessary to boost relative productivity. To sustain both growth and income distribution, it is crucial to move the relative productivity curve to the right (full line). This would allow the developing economy to attain the degree of diversification z2 without changing the RER; or higher diversification in z3 if the RER increases. This is one of the many good reasons to believe that the exchange rate policy and industrial policy needs each other.
References
However, it is not without risks betting just on the RER for competitiveness. A high RER depresses real wages. To avoid a negative impact on workers’ welfare, it is necessary to boost relative productivity. To sustain both growth and income distribution, it is crucial to move the relative productivity curve to the right (full line). This would allow the developing economy to attain the degree of diversification z2 without changing the RER; or higher diversification in z3 if the RER increases. This is one of the many good reasons to believe that the exchange rate policy and industrial policy needs each other.
References
- Cimoli, M.; Fleitas, S. And Porcile, G. (2013) "Technological intensity of the export structure and the real exchange rate," Economics of Innovation and New Technology, vol. 22(4), pages 353-372, June.
- Baldwin, R. (1988) “Hysteresis in Import Prices: The Beachhead Effect”, American Economic Review, 78, pp. 773-785.
- Baldwin R., Krugman P. R. (1989) “Persistent Trade Effects of Large Exchange Rate Shocks, Quarterly Journal of Economics, 104, pp. 635-654.
- McMillan, M. and Rodrik, D. (2001) “Globalization, Structural Change and Productivity Growth”, Joint ILO-WTO paper, February.