Exchange Rate Misalignment: Causes and Consequences

The choice between a fixed and flexible exchange rate regime has emerged as one of the central aspects within the larger debate concerning global financial architecture. My dissertation explores the often neglected aspect of exchange rate misalignment in such a context. The dissertation consists of two chapters. The first chapter ascertains whether a country's exchange rate regime has an impact on the degree of misalignment. This may be especially important for emerging economies that receive substantial capital flows. Since there is no standard definition of 'emerging' in the literature, a cluster analysis is used to define such countries in this study based on four parameters. Using a panel (102 countries, 30 years) cointegration vector estimator, I define the equilibrium exchange rate as implied by the estimator. I also classify the de facto exchange rate regime taking into account a country's effective exchange rate characteristics, which has not been previously used. The results suggest that for developing countries, an intermediate exchange rate regime (a regime between a pure oat and a hard peg) is most effective at limiting misalignment. Fixed rates perform second-best, while oats perform the worst. Also, there is no significant difference among regimes in limiting misalignment for developed countries. Using the same sample and improved measure of misalignment from the first chapter, the second chapter employs standard growth regressions to determine how exchange rate misalignment affects economic growth. I find that it does affect growth, but asymmetrically. Specifically, overvaluation significantly hurts growth while undervaluation has the opposite effect (although it is not statistically significant). Developed and developing countries are affected by misalignment to different degrees, with a greater impact for developing countries. Also, the persistence of misalignment matters in that continuing overvaluation or undervaluation are harmful. The results suggest it is not a viable strategy to intentionally undervalue a currency to improve the competitiveness of the export sector. Since the choice of regime matters for misalignment, and this can seriously affect the growth prospects of a developing country, this work suggests that properly administered intermediate regimes can help limit exchange rate misalignment that can be detrimental to growth.