Christopoulos, Dimitris K. Gente, Karine León-Ledesma, Miguel A.
Year of Publication:
School of Economics discussion papers 10,11
Empirical evidence suggests that real exchange rates (RER) behave differently in developed and developing countries. We develop an overlapping generations two-sector exogenous growth model in which RER determination may depend on the country's capacity to borrow from international capital markets. The country faces a constraint on capital in ows. With high domestic savings, the RER only depends on productivity spread between sectors (Balassa-Samuelson effect). If the constraint is too tight and/or domestic savings too low, the RER depends on both net foreign assets (transfer effect) and productivity. We then analyze the empirical implications of the model and find that, in accordance with the theory, the RER is mainly driven by productivity and net foreign assets in constrained countries and by productivity in unconstrained countries.
real exchange rate capital in ows constraint overlapping generations