School of Economics

2010 Discussion Papers

School of Economics Discussion Paper 10/11
December 2010

Net Foreign Assets, Productivity and Real Exchange
Rates in Constrained Economies

Dimitris K. Christopoulos, Karine Gente
and Miguel A. León-Ledesma
Panteion University, DEFI, University of Aix-Marseilles,
University of Kent

Abstract:

Empirical evidence suggests that real exchange rates (RER) behave differently in developed and developing countries. We develop an overlapping generations two-sector exogenous growth model in which RER determination may depend on the country's capacity to borrow from international capital markets. The country faces a constraint on capital inflows. With high domestic savings, the RER only depends on productivity spread between sectors (Balassa-Samuelson effect). If the constraint is too tight and/or domestic savings too low, the RER depends on both net foreign assets (transfer effect) and productivity. We then analyze the empirical implications of the model and find that, in accordance with the theory, the RER is mainly driven by productivity and net foreign assets in constrained countries and by productivity in unconstrained countries.

JEL Classification: E39, F32, F41

Keywords: Real exchange rate, capital inflows constraint, overlapping generations

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