The Real Exchange Rate Process and its Real Effects: The Cases of Mexico and the USA

Abstract

Exchange rate management is a salient macroeconomic issue, especially in developing countries. In this paper, we study political economy factors that may affect the real exchange rate (RER) process and the real economic effects of the RER. We review recent literature on the effects of elections on the exchange rate, and adapt Ball's (1992) model to show that uncertainty about the future course of policy may make more appreciated RER's less predictable. We also review the literature on the real effect of RER appreciations and of RER uncertainty. We then construct a simultaneous GARCH-M model of the joint determination of the RER and output capable of testing our hypotheses simultaneously in a single model. We estimate the model using data first from Mexico, a developing country, and the US. In Mexico we find that elections significantly affect the evolution of the RER, that more appreciated RERs are less predictable, that RER depreciations lower output growth and that RER uncertainty lowers output growth, even when controlling for its wellstudied effect on trade. By contrast, none of these effects are found in the US data.

Keywords: Real exchange rate volatility, economic growth, electoral cycle

JEL Classification: F3, F4, O42