Structural Change, Trade and Real Exchange Rates

Recent bodies of empirical literature have addressed the issue of real exchange rate misalignments and economic growth. Different author’s using different estimation methods have mostly found that countries which have been able to keep their real exchange rate at undervalued levels have experienced higher growth rates, especially in the case of underdeveloped and developing economies. The main argument put forward by this literature to explain this empirical regularity is that Real Exchange Rate undervaluation can enhance competitiveness of tradable sectors and help to boost exports. However, the literature has mostly used measures of real exchange rate “equilibrium”, from which misalignments are derived, in an uncritical manner. Therefore, an initial aim of this research is to develop a critical review of the different measures used in the literature, assessing their underlying hypothesis, ability to track long term trends of real exchange rate and discussing their embedded notions of equilibrium. We then propose an alternative approach proposed originally by Shaikh (1999) and further developed by Shaikh (2016) which is inspired by classical political economy. In this alternative framework, the real exchange rate of a country is essentially determined by the relative vertically integrated unit labour cost between the countries exporting sectors and its imports. Using world input-output tables, we develop an exploratory empirical application of Shaikh’s approach for the UK economy between 1995 and 2009. The results are contrasted with a traditional measure based on the Purchasing Power Parity (PPP) and reveal a better fit to track real effective exchange rate movements. This highlight that changes in real exchange rates are also a consequence of changes in the country’s relative competitive condition, represented by relative vertically integrated unit labour costs (RVIULC).