E2017002                                                2017-04-05

Rui Mao
School of Management
Zhejiang University

Yang Yao and Jingxian Zou
National School of Development
and
China Center for Economic Research
Peking University

Abstract:

This paper studies how the fixed exchange rate regime (FERR) may promote growth when a country experiences faster rates of productivity growth in its tradable sector than its nontradable sector. In a simple two-sector model, we show that the FERR can reduce the Balassa-Samuelson effect if the adjustment of domestic prices is subject to nominal rigidities. The undervaluation suppresses wage growth but increases the size of the tradable sector and leads to higher growth rates for the entire economy. Using cross-country panel data, our econometric exercises provide robust evidence that supports the results. Meanwhile, other fundamentals, including the external balance position, export share in the tradable sector, and the stage of development, play roles in determining the effects of FERR. Last, we apply the empirical results to run simulations on China from 1994 to 2007 to highlight the role of FERR in the country’s export-led growth.

Keywords: fixed exchange rate regimes; real undervaluation; export-led growth

JEL classification: F31, F43, O41

Download the full text E2017002.pdf