We show that the response of firm-level investment to real exchange rate movements varies depending on the production structure of the economy. Firms in advanced economies and in emerging Asia increase investment when the domestic currency weakens, in line with the traditional Mundell-Fleming model. However, in other emerging market and developing economies, as well as some advanced economies with a low degree of structural economic complexity, corporate investment increases when the domestic currency strengthens. This result is consistent with Diaz Alejandro (1963)—in economies where capital goods are mostly imported, a stronger real exchange rate reduces investment costs for domestic firms.

This paper analyzes the impact of capital inflows and exchange rate flexibility on the real exchange rate in developing countries based on panel cointegration techniques. The results show that public and private flows are associated with a real exchange rate appreciation. Among private flows, portfolio investment has the highest appreciation effect-almost seven times that of foreign direct investment or bank loans-and private transfers have the lowest effect. Using a de facto measure of exchange rate flexibility, we find that a more flexible exchange rate helps to dampen appreciation of the real exchange rate stemming from capital inflows.

We examine the relationship between real exchange rate depreciations and indicators of firm performance using data for a sample of more than 30,000 firms from 66 (advanced and emerging market) countries over the 2000-2011 period. We show that depreciations boost profits, investment, and sales of firms that are more financially-constrained and have higher labor shares. These findings are consistent with the view that depreciations boost internal financing opportunities by reducing real wages, thereby spurring investment. We show that these effects on firm performance are enduring, including in the market valuation of firms.

This paper employs newly constructed measures for productivity differentials, external imbalances, and commodity terms of trade to estimate a panel cointegrating relationship between real exchange rates and a set of fundamentals for a sample of 48 industrial countries and emerging markets. It finds evidence of a strong positive relation between the CPI-based real exchange rate and commodity terms of trade. The estimated impact of productivity growth differentials between traded and nontraded goods, while statistically significant, is small. Increases in net foreign assets and in government consumption tend to be associated with appreciating real exchange rates.

Originally published in 1997. This study investigates what the effects of real exchange rate volatility are on sectorial investment in the fixed and flexible exchange rate systems. It lays out the results of research into the effects of the levels and volatility of real exchange rates on investment in the manufacturing sectors of the countries in the European Monetary System as well as of the countries in the flexible exchange rate system, with data from between 1973 and 1993. Examining the differences between the two systems in the results this book also looks at exchange rate effects on interest rates at the time.

We review the literature on Dutch disease, and document that shocks that trigger foreign exchange inflows (such as natural resource booms, surges in foreign aid, remittances, or capital inflows) appreciate the real exchange rate, generate factor reallocation, and reduce manufacturing output and net exports. We also observe that real exchange rate misalignment due to overvaluation and higher volatility of the real exchange rate lower growth. Regarding the effect of undervaluation of the exchange rate on economic growth, the evidence is mixed and inconclusive. However, there is no evidence in the literature that Dutch disease reduces overall economic growth. Policy responses should aim at adequately managing the boom and the risks associated with it.

Contrary to the arguments of several scholars, we have failed to find either a conclusive theoretical case or clear empirical evidence of an effect, harmful or otherwise, of exchange rate variability (as measured by either short-term volatility or long-run misalignment) on overall levels of international trade. In this paper, after reviewing the theories and evidence on this issue, we go on to consider the impact of exchange rate variability on direct foreign investment. We summarize and amplify upon the scant theoretical literature of this issue, and proceed to test U.S. data for the presence of such an impact. We find none.