When Might an Exchange Rate Depreciation Be Growth Inducing or Contractionary?
by NGANDU, S. & GEBRESELASIE, T., 2006Research Report, Employment Growth & Development Initiative, Human Sciences Research Council
This paper forms part of an Human Sciences Research Council project on exchange rates and employment, which seeks to understand the impact of exchange rate fluctuations on employment in South Africa. The South African government has the aim of accelerating the rate of economic growth and sustaining it at higher levels. It also aims to halve poverty and unemployment by 2014. There is a clear intention that part of this strategy should involve a more meaningful expansion of traded goods and services that can lead economic growth, and can also generate employment growth. There is substantial evidence that most of the growth take-offs globally were accompanied by either a real devaluation or an undervalued exchange rate. However, most countries do not achieve high and sustained economic growth – it may be that currency under-valuation has been an important part of the growth package, but it is not sufficient to guarantee success. Instead, a currency depreciation or devaluation can also backfire, causing economic contraction. This paper considers competing views on the possible growth-inducing effects of a deliberate depreciation. It first reviews arguments for the growth-inducing impact of a currency devaluation. It then considers circumstances in which a currency depreciation might be contractionary. It is essential that any debate on exchange rate targeting be contextualised within the design of the broader policy package and economic context. For example, the East Asian countries that managed to achieve their impressive growth rates through currency undervaluation, also had convincing micro-economic policies that promoted export oriented growth. In some cases, there were also explicit policies to keep the price of capital-goods and ‘wage-goods’ (such as food) low as a counter to the negative impact on incomes that arise from a currency depreciation. In the absence of these instruments, policy-makers will hesitate to target the exchange rate in this way for fear of macroeconomic instability, weakened balance of payments and worsening unemployment.
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