First, undervaluation has a positive effect on the relative size of the tradable sector, and especially of industrial economic activities.
The first four columns in table 7 report standard panel regressions where five-year-average sectoral shares (in real terms) are regressed on income, a complete set of fixed effects, and my measure of undervaluation. I initially lumped agriculture and industry together in constructing the dependent variable, since both are nominally tradable, but as these regressions show, they have quite a different relationship with real exchange rates.
The last two columns of table 7 report results of two-stage panel growth regressions (with, as before, a full set of fixed effects) that test whether the effect of undervaluation on growth operates through its impact on the relative size of industry.
They break the undervaluation-growth relationship into two separate links, one from undervaluation to the size of tradables (that is, industry) and the other from the size of industry to economic growth.
Real undervaluation can then act as a second-best mechanism for spurring growth of tradables and for generating more rapid overall economic growth.
Specifically, the growth impact of undervaluation should be greater in those countries where this "taxation" is greatest, namely, the countries with the weakest institutions.
The positive effect of undervaluation is strongest in the below-average group and virtually nil in the above-average group.
The analytics of how institutional weakness interacts with undervaluation to influence growth will be developed further in the next section.
Note that once again this is a second-best argument for undervaluation. First-best policy would consist of identifying distinct market failures and applying the appropriate Pigovian remedies.
The recent findings of Caroline Freund and Martha Pierola are particularly suggestive in this connection: currency undervaluation appears to play a very important role in inducing producers from developing countries to enter new product lines and new markets, and this seems to be the primary mechanism through which they generate export surges.
That is why episodes of undervaluation are strongly associated with more rapid economic growth.
Are my quantitative estimates of the growth effects of undervaluation plausible?