Real Exchange Rates, Trade, and Growth: Italy 1861-2011

Abstract

What is the relationship between real exchange rate misalignments and economic growth? And what effect, if any, did undervaluations or overvaluations of the lira/euro have on Italy's growth? We address these questions by presenting, first, three main facts: (i) there is a positive relationship between undervaluation and growth; (ii) this relationship is strong for developing countries and weak for advanced countries; (iii) these results tend to hold for both the pre- and the post-World War II period. Building a simple analytical model, we explore channels through which undervaluation may exert a positive effect on real GDP. We assume that productivity is higher in the tradeable-goods than in the non-tradeable-goods sector, and examine the roles of market structure, scale economies and wage flexibility in channelling resources from the latter to the former sector, increasing exports and real GDP. We then turn to Italy and verify empirically that, as the theory suggests, undervaluation has positively affected its exports. Undervaluation has been helpful, in particular, to increase the exports of high-productivity sectors, such as most manufacturing industries. Finally, we describe the misalignments of the lira/euro since 1861, analyze their determinants and draw the implications for Italy's economic growth.Currency misalignments, Competitiveness, Italy, Export, Growth