Exchange Rate Flexibility and the Effect of Remittances on Economic Growth

• Author: Emmanuel K. K. Lartey
• Date: 01 February 2017
• Published date: 01 February 2017
• DOI: http://doi.org/10.1111/rode.12256

Exchange Rate Flexibility and the Effect of

Remittances on Economic Growth

Emmanuel K. K. Lartey*

Abstract

This paper studies the question of whether exchange rate policy affects the impact of remittances on

economic growth in recipient countries. The findings indicate that more flexible exchange rate regimes

are associated with a greater increase in economic growth following an increase in remittances, but also

that the impact of remittances on growth is positive under a fixed regime. The results further show that

the effect of remittances under a fixed exchange rate regime is positive in less financially developed

countries as well, but do not provide conclusive evidence that this effect varies inversely with exchange

rate flexibility in such economies as theorized; the results being sensitive to the choice of financial

development indicator.

1. Introduction

There is an extensive literature on the linkage between exchange rate regimes and

economic growth with no consensus on the nature of the relationship. A key

argument, among several, that has been advanced in favor of flexible regimes is

that they enhance economic growth by facilitating adjustments to real shocks

originating from both domestic and foreign sources, in the presence of nominal

rigidities. This, therefore, suggests that a fixed regime renders the economy

susceptible to greater macroeconomic volatility and should have an adverse impact

on growth. A contrasting theoretical argument is that a flexible regime is a source

of macroeconomic uncertainty, as it allows the propagation of negative external

shocks and hence dampens growth. Thus, in this case, a fixed regime is favored to

provide an environment that enhances growth through a decline in uncertainty and

limited variability in the interest rate.

This paper addresses the debate on whether exchange rate regimes matter for the

impact of remittances on economic growth in recipient countries. It is well

documented that countries, in the past, have resorted to combatting inflationary

consequences and the concomitant real exchange rate appreciation effects of capital

inflows by pegging their exchange rates under the notion that this would help their

external competitiveness and thereby enhance their efforts at utilizing those capital

inflow resources to enhance productivity and growth. Remittances, as has been

observed, could act as private capital inflows, and given that they could negatively

impact economic growth through an appreciation of the real exchange rate and

contraction of the tradable sector, it is important to empirically assess the role

*Lartey (Corresponding author): Department of Economics, California State University, Fullerton, 800

N. State College Blvd, Fullerton, CA, 92834, USA. Tel: +1-657-278-7298; Fax: +1-657-278-3097; E-mail:

elartey@fullerton.edu. The author is grateful to Andrew Gill, Larry Howard, Sambit Bhattacharyya

(associate editor) and anonymous reviewers for providing very helpful comments. The usual disclaimer

applies.

Review of Development Economics, 21(1), 103–125, 2017

DOI:10.1111/rode.12256

©2016 John Wiley & Sons Ltd

exchange rate regimes play in driving the economic growth dynamics in recipient

economies.

Several indirect channels through which exchange rate regimes could affect

growth have been identified. These include the level of financial development,

investment and international trade.

1

Aghion et al. (2009) find evidence that more

financially developed countries grow faster under a more flexible regime. They also

observe a negative relationship between productivity growth and flexible regimes in

less financially developed countries. The main idea is that firms in countries with

higher levels of financial development are able to survive liquidity shocks that

accompany exchange rate fluctuations and contribute to innovation and long-run

growth. Such exchange rate volatility tends to have negative effects on long-run

growth in less financially developed countries as they discourage investments.

Bailliu et al. (2003) note that the indirect route is based on the certainty or

uncertainty triggered by the exchange rate regime and the impact of that on trade

and investment.

In a study that analyzes the implication of exchange rate policies for the dynamics

of sectoral output and nontradable inflation in an economy that is subject to

remittance shocks, Lartey (2015) shows that under a fixed exchange rate regime, an

increase in remittances leads to an increase in consumption of nontradable goods and

a rise in nontradable inflation. For an inflation targeting regime, though, an increase

in remittances leads to an expansion of the tradable sector and a decline in

consumption of nontradables, which reduces nontradable inflation. The findings also

indicate that a near-zero nontradable inflation rate and a managed variability in the

nominal exchange rate characterizes the optimal monetary policy, suggesting that an

inflation targeting regime is preferable to a fixed exchange regime. An empirical

assessment of the theoretical model using vector autoregression analysis indicates that

these observations are generally consistent with the dynamics of inflation induced by a

shock to remittances in El Salvador, which is representative of an economy that

operates a fixed exchange regime, and the Philippines, which typifies an economy with

an inflation targeting monetary regime.

It may be argued then, that exchange rate regimes could facilitate or undermine

economic growth directly, to the extent that they curtail or precipitate Dutch

disease effects of remittances respectively, through their impact on resource

reallocation, which in turn has implications for economic growth. In addition,

exchange rate regimes could have an indirect effect on how remittances impact

growth, particularly in the case where remittances act as investment capital.

Furthermore, given that exchange rate policies have implications for

macroeconomic (un)certainty and the transmission of negative external shocks, the

choice of exchange rate regimes could serve to provide desirable macroeconomic

environments for remittances to positively affect growth or otherwise.

On that account, this study contributes to the literature by examining the

question of whether the relationship between remittances and economic growth is

affected by exchange rate policies in recipient countries. The paper also analyzes

whether exchange rate flexibility diminishes the growth effects of remittances in

countries with low levels of financial development. Furthermore, this study differs

from the extant literature, in that it utilizes a comprehensive data set on 135

developing and transition countries representing different income groups, and

employs estimation techniques that address potential endogeneity issues that exist

between gross domestic product (GDP) per capita growth on one hand, and

exchange rate regimes and remittances on the other hand.

104 Emmanuel K. K. Lartey

©2016 John Wiley & Sons Ltd