Exchange rate misalignment and economic growth : evidence from nonlinear panel cointegration and Granger causality tests

Abstract

The importance of exchange rate in an economy can be seen in the various policies implemented to manage its level and evolution on a daily basis. A large body of literature has analyzed the impact of exchange rate, or its deviation from certain equilibrium, on economic growth. The correlation between exchange rate undervaluation and economic growth is among the most investigated open macroeconomics topics. However, the question is ”does exchange rate undervaluation truly growth enhancing? The purpose of this study is to analyze the impact of exchange rate misalignment on economic growth for a sample of emerging economies from 1970 to 2014 using a panel smooth transition regression (PSTR) vector error correction model. Besides, we provide a Granger causality test conducted in a non-linear framework. We find that a rise in misalignment increases significantly output in the short-run when currencies are close to equilibrium. When they are highly misaligned, the impact on growth is reduced. However, no significant impact of output on misalignment was found in the short-run. We provide evidence that misalignment Granger causes output at any given level of misalignment both in the short and long-run. A weaker Granger causality was found between output and misalignment. This raises some important implications. Although emerging economies can use undervaluation as a growth strategy, the benefits are smaller the larger the undervaluation. There is therefore an incentive to keep exchange rates closer to their equilibrium