Inequality, the Price of Nontradables, and the Real Exchange Rate : Theory and Cross-Country Evidence

Even though real exchange rate has an important impact on sustainable export and economic growth for small open economies, its impact on income distribution and transmission mechanism was never investigated. The paper shows that improved income distribution, through its impact on the price of nontradables, is associated with real exchange rate devaluation. Min provides theoretical and empirical evidence of a negative association between income inequality and real exchange rates. First, he builds a theoretical model showing the transmission mechanism from inequality to real exchange rates. Second, using cross-country data, he demonstrates that the theoretical argument has empirical support. The association is large, significant, and robust to alternative specifications of the reduced form model and estimation methodologies.These findings provide empirical support for Poverty Reduction Strategy Papers, government strategies agreed on with the World Bank that hinge on four major objectives: accelerating equity-based growth, guaranteeing access to basic social services for the poor, expanding opportunities for employment and income-generating activities for the poor, and promoting good governance. The author's analysis indicates that quot;equity-based growthquot; and quot;export-driven growthquot; are compatible policy goals. But the negative relationship between inequality and real exchange rates does not imply that policies aimed at dramatic redistribution will automatically lead to real depreciation of the domestic currency, improve the external balance, and accelerate economic growth.This paper - a product of the Poverty Reduction Group, Poverty Reduction and Economic Management Network - is part of a larger effort in the network to provide theoretical and empirical evidences for the Poverty Reduction Strategy Papers