Inequality, the Price of Nontradables, and the Real Exchange Rate

Abstract

This paper provides theoretical and empirical evidence of a negative association between income inequality and real exchange rates. First, we build a theoretical model showing the transmission mechanism from inequality to real exchange rates. Second, we demonstrate that the theoretical argument have empirical support using cross-country data. The magnitude of association is large, significant, and robust to alternative specifications of the reduced form model and estimation methodologies. Those findings provide empirical support for PRSP since this study indicates that “equity-based growth” and “export-drive” are compatible policies. However, the robustly negative relationship between real exchange rates and inequality does not imply that dramatic distributive policies will automatically bring real depreciation of the domestic currency, improve the external balance, and accelerate economic growth.