The Critical Role of Exchange Rates in Economic Development

An exchange rate is a ratio used to convert one currency to another. Let’s say $1 was worth €1.13 in this case. All types of currencies are exchanged on worldwide foreign exchange markets, which affect the daily foreign exchange rate. One of the most often traded currencies in the world is the euro, which is used alongside the US dollar, the Japanese yen, and the British pound. In this article, we’ll abbreviate Real Exchange Rate to RER.

Role of Exchange Rates in Economic Development

There are two main and interrelated problems that are addressed in economics books and academic economic journals on developing economies’ exchange rate strategies.

The exchange rate is critical to the economy’s ability to diversify. This perspective holds that for dynamic development, it is critical to scale up to activities with greater technical content, and good exchange rate policies will enable this. Diversification has shown to be a success in East Asia, first with newly industrializing nations like South Korea and now with China. In contrast, many natural resource-dependent countries have the additional challenge of diversifying their production and export patterns due to their appreciating currency rate and premature deindustrialization.

Real Exchange Rate and the Economic Development

Competitive, stable, and many RER policies are needed in the presence of at least some learning spillovers and regulations that impede subsidy implementation. Applying the policies to their fullest optimum results means countries with varied spillover effects use different RER across sectors while adhering to the IMF’s commitment to preventing multiple exchange rates.

To the extent that any policy that has the ability to redistribute factors of production in order to allocate the economy’s resources towards sectors with significant learning spillovers has the potential to be of greater social welfare, such policy should be pursued. Under such circumstances, like it’s given on this link, subsidies and transfers are the first-best policy response. However, if RER policies cannot be implemented, RER policies may be an acceptable second-best option. When competitive, an upgraded RER will lead to a positive effect on tradable industries. However, in certain economies, many tradable sectors exist, as well as sectors that lack learning spillovers. To accomplish the goal of distributing the advantages of exchange rate policies to the appropriate sectors, that is, those with more externalities, the best course of action is to tax the sectors with no learning spillovers and provide exemptions to those with learning spillovers. It results in a system of many exchange rates that are used efficiently.

In addition to the exchange rate level, a currency’s stability is important. In nations where it is difficult or expensive to offset exchange rate swings, as well as when capital markets have other flaws, it is particularly essential to use a hedging strategy. To eliminate investment risk in the emerging tradable industries, exchange rate stability is essential. A currency which has demonstrated notable stability in relative terms may become known as a safe-haven currency.

A first caution you should be aware of describes how complementary industrial policies such as RER are valuable when working in tandem with other conventional industrial policies. Supply elasticity is poor if non-natural resources tradable industries, the policies want to develop, have inadequate access to technology, finance, and sufficient infrastructure and human capital. A traditional industrial policy may be used to help improve the currency’s flexibility. Providing commercial property and infrastructure loans through national development banks – a tool utilized extensively by industrialized nations, especially Germany and Japan, but also many emerging economies, frontier markets and developing countries – is one of those conventional strategies. To help bring about the outcome, investments in infrastructure, education, and R&D would contribute to it.

The second caution deals with the issues involved in society’s overall gains and losses as a result of implementing these policies. Higher marketable goods and services prices in terms of the local currency imply greater “undervalued” RER. As a result, pursuing a strategy of increased competitive RER results in reduced tradable goods buying power now, with the goal of increased tradable goods purchasing power in the future. Distributive effects result from these trade-offs: Everyone pays a “price” now, but whose sectors of society will gain in the future is uncertain. Competitive RER policies need social actors to collaborate and compromise, which may be challenging to accomplish.

Possible external costs to other nations may include such things as lost trade opportunities if the country implementing such a policy is a major participant in global commerce. It may need a reduction in the organization’s ‘education sector.’ Additionally, if many rising and developing nations were to implement similar policies, the total impact would be less since the effects would be split across fewer economies.

Exchange Rates and Policy Instruments

Regulation and interventions in the capital account and the foreign exchange market may be utilized to preserve a competitive real exchange rate. Long-term impacts on the RER may be brought about by capital account policies, especially those which influence the private sector’s access to foreign capital. Such interventionist measures and the buildup of foreign currency reserves go hand in hand. By examining China’s experience, we can see how some processes operate. Despite the appreciation pressures, through capital account regulations and substantial foreign currency reserves, appreciation forces were resisted.

Countries are often wary of placing the emphasis on capital account interventions, preferring to favor operations in foreign currency markets. The development of such practices has grown much more common in developing and rising nations after the 1997 East Asian financial crisis. According to the prevailing perspective of the 1990s, which held that only polar regimes such as fixed exchange rates or floating exchange rates were feasible, emerging and developing nations have shifted towards an intermediate regime that employs floating exchange rate flexibility.

A recent study has shown that these interventions that had previously been found to be effective have the capability to stabilize the overall economy and foster development, even over-turning the previous findings of the 1980s which were generally uninterested in supporting such initiatives.

Stable and competitive real exchange rate (SCRER) policies have shown to be beneficial for economic growth via a number of historical experiences. We have argued that an optimum policy plan may be implemented if certain restrictions on the policy instruments are accepted. Two basic issues are overlooked in the argument against interventions such as this one: First, these interventions do not take place in the absence of market meddling. Second, efficiency does not inevitably follow.

No market exchange rate exists; all economies and particularly developing and rising markets are plagued by market imperfections, including externalities (such as learning).

We discovered that currency interventions and capital account rules may help control exchange rates and the fluctuations in external finance and the conditions of trade, which aid growth and stability.