Real Exchange Rates and Income Distribution

Fevereiro, José Bruno Ramos Torres (2022). Real Exchange Rates and Income Distribution. PhD thesis The Open University.

DOI: https://doi.org/10.21954/ou.ro.00014ec3

Abstract

This thesis is composed of three distinct but related analysis around the topic of real exchange rate theories. First, based on Lakatos (1971) Methodology of Scientific Research Programmes (MSRP) framework, I provide a reappraisal of the origin and evolution of Purchasing Power Parity (PPP) theory in Cassel’s economic thought. A critical review of Cassel’s writings on PPP reveals that the formulation of the theory and how Cassel himself interpreted the theory went through significant changes from his initial presentations, starting from 1916, to the early 1930’s. From this starting point, the intended contributions are two-fold. First, it traces the shifts in the formulation of the theory introduced by Cassel to the critiques emerging from contemporary authors within the academic debates. I argue that, while the introduction of these adjustments made his formulation of the theory ‘internally’ more consistent, it also insulated the core theoretical proposition from falsification by empirical counter-examples. Thus, a second intended contribution of the research is to propose an assessment of these changes based on Lakatos framework of MSRP. The use of this framework enables one to better understand how these changes can be related to the rise and eventual decline of PPP theory in the academic and policy debates of the 1920’s.

Following this historical excursus into the origins of PPP theory, the research moves to a theoretical analysis of the income distribution implications of the so-called Harrod-Balassa-Samuelson effect. I provide a formalization of this effect in a two-sector prices of production model, where both the tradable and the non-tradable commodities are used as intermediate inputs, to study the co-evolution of the real exchange rate and wage share within countries. Under constant profit rates, when both commodities are used as intermediate inputs, I demonstrate that the relationship between real exchange rate and the wage share depends on the ratio with which tradable and non-tradable commodities physical output are used as intermediate input in the production of both sectors.

Lastly, the research develops a panel-data econometric analysis of the relationship between the real exchange rate and wage share across a sample of 118 countries, for the period of 1970-2014, using data from the Penn-World Table (version 9.1). The empirical results point to a different relationship between the real exchange rate and the wage share according to the countries level of economic development. At low levels of economic development, at which previous literature has found a positive effect of real exchange rate undervaluation on economic growth, a devaluation of the real exchange rate appears to be associated with an increase (decrease) in the wage share (profit share), contrary to what would be expected by previous literature. These results call for a re-assessment of the mechanisms through which real exchange rate undervaluation is allegedly stimulating economic growth in developing economies.