When are fixed exchange rates an appropriate policy tool for growth?

Abstract

This policy brief discusses how a fixed exchange rate regime (FERR) may promote economic growth by undermining the Balassa-Samuelson effect. When total factor productivity (TFP) is faster in the industrial sector than in the non-tradable sectors, an FERR can suppress the Balassa-Samuelson effect if adjustment of domestic prices is subject to nominal rigidities. In a companion paper we are able to estimate the home country’s industrial-service (quasi-) relative-relative TFP in comparison with the United States. Applying those estimates, our econometric exercises then provide robust results that an FERR dampens the Balassa-Samuelson effect and that the real undervaluation that ensues does indeed promote growth. We also explore the channels for undervaluation to promote growth. Lastly, we compare industrial countries and developing countries and find that an FERR has more significant impacts on developing countries than on industrial countries. However, real exchange rate management only works when a country is well prepared in terms of its economic fundamentals. As China has developed tremendously during the past two decades, it may be that the policy of fixed exchange rate is no longer appropriate.