The Adverse Effects of Real Exchange Rate Variability in Latin America and the Caribbean

Abstract

The paper examines the pros and cons of anticipated appreciation and the asymmetric effects of short-term exchange rate fluctuations in a sample of countries in Latin America and the Caribbean. On the demand side, exchange rate depreciation increases competitiveness and export growth, expanding output growth. On the supply side, depreciation increases the cost of imported inputs, increasing output capacity constraints and accelerating price inflation. The time-series evidence indicates that output expansion (contraction) and price deflation (inflation) predominate with anticipated currency appreciation (depreciation). The cross-country results show that exchange rate variability exacerbates the variability of economic activity across countries. Short-term fluctuations of the exchange rate may reflect the adverse effects of unanticipated currency fluctuations. Therefore, more flexibility towards aligning the real effective exchange rate with the underlying fundamentals could help mitigate the adverse effects of higher cost of imports and loss of competitiveness on real growth, and ease inflationary pressures.

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