Real exchange rate uncertainty and economic performance in Mexico, 1971-1996

Abstract

In this paper we consider two empirical questions. First, is there a real Exchange rate (RER) uncertainty effect on economic growth independent of its potential effects on trade? Second, is there a relationship betwecn the level of the real exchange rate and its conditional variance? Using a multivariate GARCH-M model, we estimate a simultaneous model of the RER-economic growth process in Mexico from 1971 through 1996. We find that the conditional variance of the RER has a negative and significant influence on Mexican industrial production growth, controlling for industrial production growth in the USA, the level of the RER, and Mexican export growth. We also find that there is a positive and significant relationship between the level and conditional variance of the RER. That is to say, as the peso experiences real appreciation, its conditional variance rises. Taken together, these results imply that real exchange rate uncertainty is a problem for economic growth, and one way to combat the problema is to avoid RER appreciations unrelated to improved fundamentals. Our results are novel in that they provide the first time series evidence of a link between RER uncertainty and economic growth, and the first evidence that RER appreciation increases RER uncertainty.