Is an undervalued currency the key to economic growth?

The short answer seems to be no. A recent paper by Michael Woodford argues that the evidence in favour of an positive link between an undervalued currency and economic growth is less persuasive than some authors, Dani Rodrik being one, suggest. This is for two reasons. First, some papers exaggerate the strength and robustness of the association between the real exchange rate and growth in the cross-country evidence. And second, even granting the existence of such a correlation, a causal effect of real exchange rates on growth is hardly the only possible interpretation.

The abstract of the Woodford paper reads,

Dani Rodrik (2008) offers a provocative argument for policies that seek to maintain an "undervalued" exchange rate in order to promote economic growth. The key to his argument is the empirical evidence that he presents, indicating correlation of his measure of undervaluation with economic growth in cross-country panel regressions. Rodrik does not really discuss the measures that should be undertaken to maintain an undervalued exchange rate, and whether it is likely that a country that pursues undervaluation as a growth strategy should be able to maintain persistent undervaluation. For example, he remarks (as justification for interest in the question of a causal effect of undervaluation on growth) that "one of the key findings of the open-economy macro literature is that nominal exchange rates and real exchange rates move quite closely together." But while this is true, and while it is widely interpreted as indicating that monetary policy can affect real exchange rates (since it can obviously move nominal rates), it hardly follows that monetary policy alone can maintain a weak real exchange rate for long enough to serve as part of a long-run growth strategy. Indeed, conventional theoretical models with short-run price stickiness, that are perfectly consistent with the observed short-run effects of monetary policy on real exchange rates, imply that monetary policy should not have long-run effects on real exchange rates. Rodrik also cites evidence showing that sterilized interventions in the foreign-exchange market can affect real exchange rates. But economic theory suggests that interventions not associated with any change in current or subsequent monetary policy should have even more transitory effects. And the experiences of countries that have sought to use devaluation to boost economic growth have often found that the real exchange rate effect of a nominal devaluation is not long-lasting. Nonetheless, the point of the paper is to provide evidence that undervaluation favors growth, on the assumption that policies to maintain undervaluation are avail- able, and it is that central contention that I shall examine here. I find the evidence less persuasive than the paper suggests, for two reasons. First, I believe that the paper exaggerates the strength and robustness of the association between the real exchange rate and growth in the cross-country evidence. And second, even granting the existence of such a correlation, a causal effect of real exchange rates on growth is hardly the only possible interpretation.