Abstract

This chapter analyzes the operation of the balance-of-payments (BoP) constraint on developing economies, with a special emphasis to the link between inflation targets, real-exchange-rate dynamics and growth in the short and in the long run. The analysis starts with a brief survey of the main models of the BoP constraint. Using a “canonical” BoP-constraint model, the chapter investigates how inflation targets can influence growth in the long run through the impact of real exchange rates on the income elasticities of exports and imports. Based on Woo (2005) and Frenkel and Taylor (2006), the basic theoretical argument is that short-run inflation management may imply substantial and prolonged changes in real exchange rates, which in their turn may not only increase financial fragility, but also change the very own BoP constraint on growth in the long run. The main conclusion of the chapter is that the real exchange rate can be an important instrument to foster growth and development through temporary but sufficiently long changes in the relative price between tradable and non-tradable goods.

Introduction

The Balance-of-Payments (BoP) constraint is one of the most important determinants of growth in developing economies. More specifically, since developing countries cannot issue the international currency and usually face liquidity constraints in international financial markets, they tend to adjust their current account to the availability of foreign finance. In such a process, both the exchange rate and the GDP growth rate are constrained to produce the adjustment of the current account to the international financial conditions.