de Janvry and Sadoulet
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.
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.