Output and the real exchange rate in developing countries: an application to Mexico

Since Mexico's devaluation in 1994, some observers have called for policies designed to keep the real exchange rate highly competitive in order to promote exports and output growth. However, over the past few decades, devaluations have been associated nearly exclusively with economic contraction, while real appreciations have been followed by expansions. We attempt to disentangle the possible factors underlying this correlation (1) reverse causation from output to the real exchange rate, (2) spurious correlation with third factors such as capital account shocks, and (3) temporary contractionary effects of devaluation - and determine whether a positive long-run effect of real depreciation on output is in the data. Based on the results of several VAR models, we conclude that even after sources of spurious correlation and reverse causation are controlled for, real devaluation has led to high inflation and economic contraction in Mexico. While changes in Mexico's economic structure and financial situation may qualify the future applicability of this conclusion, our findings point to substantial risks to targeting the exchange rate at too competitive a level. (C) 2000 Elsevier Science B.V. All rights reserved. JEL classification: F41; F31.