The relationship between exchange rate and structural change: an approach based on income elasticities of trade

Abstract

We analyse the hypothesis that variations in the income elasticities of the demand for exports and imports are influenced by the difference between the actual and industrial equilibrium levels of real effective exchange rates. The industrial equilibrium is defined as the exchange rate level that equalises real unit labour costs between local producers of manufactured goods and their trading partners. To test our hypothesis, based on data between 1995 and 2014 from the World Input-Output Database (WIOD), a sample of 43 countries was built. First, the actual and the industrial equilibrium real effective exchange rates were calculated; then, the income elasticities were estimated for each country during this period. A dynamic panel data model was adopted to estimate the relationship between these elasticities and the differences between those exchange rates. The results suggest that the magnitude of these differences modifies the income elasticities of trade, potentially contributing to structural change.