Undervaluation, Financial Development, and Economic Growth

This paper analyzes the effect of undervaluation on economic growth in the presence of borrowing constraints. Based on a two-sector, small open-economy model, we show that undervaluation can promote economic growth by partly correcting distortions in financial markets through the channels of increased within-sector productivity and the relative share of the tradable sector in an economy. Such an effect is magnified amid tight borrowing constraints. We empirically test the theoretical conclusions using cross-economy data for the period 1980–2011. For economies whose level of financial development lies at the 25th percentile of our sample, a 50% undervaluation can boost the economic growth rate by 0.3 percentage points. There is an additional 0.045 percentage point increase in economic growth with a 10% decline in the financial development measure.