Chapter9 RER - de Janvry and Sadoulet 1 Chapter 9...

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de Janvry and Sadoulet 1 1 Chapter 9 International Finance and Development: Exchange Rates and Foreign Capital Flows Revised September 28, 2010 1. Exchange rates and development Because they determine the international value of domestic resources, exchange rates play an important role in international trade and finance. Classical trade theory suggests that “only relative prices matter”, i.e., that comparative advantage comes from relative domestic resource costs and does not depend on the nominal comparison of the value of currencies. If we lived in a simple global barter economy, this would be true – only physical goods would circulate between countries, converted to local currency prices on arrival. This was more typical of ancient trade, but the desire to carry purchasing power (financial capital) across borders is also very old. Today, international capital markets exist completely in tandem with international flows of goods and services. As a result, demand for currency conversion services now totals billions of dollars a day in the spot market and trillions in the foreign exchange derivatives markets. The scale of these activities means that macroeconomic policy, in developed and developing countries alike, must include international financial flows. In this chapter, we provide a general overview of international finance issues as these are relevant to LDC economies. The two main categories of interest are exchange rates and foreign direct investment. In this chapter, we discuss exchange rates and how they link the real and financial realms of economic policy. 1 We are indebted to David Roland-Holst for writing the first draft of this chapter. Take home messages for chapter 9 1. With globalization, international financial flows from FDI, FPI, and remittances have become increasingly important determinants of domestic economic growth and stability. Thus an understanding of international finance is fundamental to understand development. 2. One of the main links between international financial flows and the domestic economy is through the exchange rate. The exchange rate appreciates (the domestic currency gains strength) when it goes down as measured in LCU/$ and depreciates when it goes up. 3. Exchange rate regimes can be flexible, fixed, or dollarized. Each regime can only achieve two of the three policy goals: exchange rate stability, freedom of capital movements, and monetary autonomy. 4. The real exchange rate (RER) is the ratio of the price of tradable to non-tradable goods. It has a strong impact on the real balances in the economy. An appreciation of the RER shifts domestic production from tradable (agriculture, industry) to non-tradable goods (services), and shrinks the balance of trade. The Chinese Yuan is held highly depreciated, favoring Chinese exports and penalizing imports.
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Chapter9 RER - de Janvry and Sadoulet 1 Chapter 9...

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