This book builds on the theme that distortions inherent in free currency markets lead LDCs systematically to misallocate resources. The intuition behind this theme is traightforward. Consider an equilibrium situation in the real world, where a bundle of resources produces tradables or nontradables, measured such that one unit of each is worth $1. Entrepreneurs should be indifferent between producing one unit of tradables or one of nontradables. Now introduce a slight complication that is ubiquitous in the real world of LDCs: tradables trade in dollars, a hard currency, whereas nontradables trade, say, in pesos, which is a soft currency. The soft currency may be devalued. Then it becomes risky for the Mexican entrepreneur to produce (or hold) one unit of nontradables that could not be converted into $1 for later spending. Expressed in another way, entrepreneurs are attracted to producing tradables because that is the only way they can acquire $1 they wish to hold for asset purposes. Thus, relative to productivities measured at “normal” prices, nontradables become undervalued and resources are drawn away towards tradables. This is manifest in a relative price of nontradables that is too low compared with productivities, or too high an RER.

This dilemma does not exist for the DC producer. In hard currency, $1 of tradables will always be worth $1 of nontradables, as opposed to the soft currency, where the expectation of devaluation becomes a self-fulfilling prophecy. In the process of converting soft currency into hard for asset-holding purposes the market-clearing NER becomes too high. This is manifest in a relative price of tradables that is too high compared with productivities – again too high an RER.