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Abstract:
Since Mexico's devaluation of the peso in 1994, some observers have called for
policies designed to keep the real exchange rate highly competitive in order
to promote exports and output growth. However, over the past few decades,
devaluations of the real exchange rate have been associated nearly exclusively
with economic contraction, while real appreciations have been followed almost
invariably by expansions in economic activity. The purpose of this paper is
to attempt to disentangle the possible factors underlying this
correlation--(1) reverse causation from output to the real exchange rate, (2)
spurious correlation with third factors such as capital account shocks, and
(3) temporary contractionary effects of devaluation--and determine whether,
once those factors are accounted for, a positive, long-run effect of real
depreciation on output can be identified in the data. Based on the results of
a VAR model designed to explore the linkages between the real exchange rate
and output, we conclude that even after sources of spurious correlation and
reverse causation are controlled for, real devaluation has led to high
inflation and economic contraction in Mexico. While changes in Mexico's
economic structure and financial situation may qualify the future
applicability of this conclusion, we view our findings as pointing to
substantial risks to targeting the exchange rate at too competitive a level.
Full paper (335 KB PDF)
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