Real Exchange Rate Policy for Economic Development

This paper analyzes the role of real exchange rate (RER) policies for promoting economic development. Markets provide a suboptimal amount of investment in sectors characterized by learning spillovers. We argue that a stable and competitive RER policy may correct externalities and other market failures, enabling the development of sectors with a larger contribution to inclusive economic growth. Optimality also requires a system of multiple effective exchange rates, where sectors with negative externalities or with smaller learning spillovers are more heavily taxed. We argue that RER policies must be complemented by traditional industrial policies that increase the elasticity of the aggregate supply to the RER. We also discuss the challenges and trade-offs associated with RER policies, and we describe a variety of instruments that can be used for their implementation.