The paper examines how real exchange rate volatility affects productivity growth and how this relationship depends on a country's level of financial development. It finds that the impact of exchange rate volatility on growth varies according to a country's financial development - volatility has a more negative impact in countries with lower financial development. The authors develop a theoretical model to explain this finding, where financial development determines firms' ability to finance innovation costs during exchange rate fluctuations. However, some comments note issues with the empirical specifications and question aspects of linking the model to the empirical results.

1. Exchange Rate Volatility
and Productivity Growth:
The Role of Financial Development
Aghion, Bacchetta,
Ranciere, and Rogoff
Comments by Valerie Cerra

2. Main point
 Real exchange rate volatility, and thus
the exchange rate regime affect growth
 Impact depends on the country’s level of
financial development

3. Related Literature on exchange
rate regimes and growth
 Ghosh, Gulde & Wolf: hard pegs work
best
 Sturzenegger & Levy-Yeyati: floats are
best
 Reinhart-Rogoff: lntermediate flexibility
performs best

4. Correlations Among Regime
Classification Schemes
(Frequency of outright coincidence, in %, given in parentheses)
IMF Ghosh LY-S R-R
1.00
IMF
(100.0)
0.60 1.00
Ghosh
(55.1) (100.0)
0.28 0.13 1.00
LY-S
(41.0) (35.3) (100.0)
0.33 0.34 0.41 1.00
R-R
(55.1) (35.2) (45.3) (100.0)
(Frequency of outright coincidence, in %, given in parenthesis.)
Sample: 47 countries. From Frankel, “Experience of and Lessons from Exchange Rate
Regimes in Emerging Economies,” in Monetary and Financial Integration in East Asia,
ADB, 2004. Table 3, prepared by Marina Halac & Sergio Schmukler.

5. Empirical finding

6. Empirics: robustness tests
 Alternative measures: real ex rt volatility, real
ex rt overvaluation, Reinhart Rogoff regimes,
Gosh et al regimes, Levy-Yeyati and
Sturzenegger
 Time windows
 Measures of financial development
 Crisis dummies
 Continents
 Nonlinearities

7. Theoretical mechanism
 Productivity growth occurs through innovation
that requires payment of liquidity cost
 If country has low level of financial
development, liquidity cost must be paid
through operating profits
 Nominal wages are sticky one period and
Pt = St due to PPP assumption
 Operating profits depend on price (thus ex rt)
surprises that generate real wage losses

8. Theoretical mechanism
 Unexpected nominal appreciation
 lower price level and higher real wage
than expected
 High operating profits fund the liquidity
cost
 higher productivity growth
 Unexpected nominal depreciation
lower productivity growth

9. Theoretical mechanism:
Exchange rate volatility and growth
 Probability of innovation profits
Financial development
Concave distribution
of liquidity cost shocks Cost of innovation

10. Comments: Empirics
 Useful finding that exchange rate
regime has macro impact
 But is it a story about real exchange rate
volatility rather than regime?
 Robustness of regime classification: LYS
not significant—free fall or dual ex rt?

11. Comments: Empirics
 All relevant control variables present?
• Savings or investment rates
• Political crises and wars
• Capital account openness
• Govt investment, esp infrastructure
• Govt deficits or debt overhang
 Proper lags?
• Secondary enrollment

12. Measure of financial
development
 Private credit to GDP – often used to measure financial
development for long-term growth
 Hardy and Pazarbasioglu (1998) – boom and bust pattern in
advance of banking crises. Kaminsky and Reinhart (1996) –
growth in domestic credit to GDP accelerates steadily and
markedly as the crisis approaches, peaking at the time the
crisis erupts.
 Sachs, Tornell, and Velasco (1996), Radelet and Sachs
(1998) and Corsetti, Pesenti, and Roubini (1998) argue that
this measure proxies for financial fragility, as the quality of
bank loans is likely to deteriorate significantly when bank
lending grows at a rapid pace in a relatively short period of
time.
 Five year averages and within country estimation – relates to
short-term changes, thus possibly financial fragility rather
than development

13. Use of 5 year growth averages
 To “filter out business cycle fluctuations”
 Standard, but only true if there are business cycle
fluctuations
 Cerra and Saxena, 2005, “Growth Dynamics: The
Myth of Economic Recovery”
• No “cycles” – Shocks are permanent
 Nominal wage rigidity much shorter than 5 years
 Model relies on operation profits changing due to
business cycle mechanism, so why filter?
 Measure of financial development argues for
between country regressions

14. Empirics
 Verify whether there is a weak
instrument problem using lags of
variables as instruments in GMM?
 Heterogeneity in the estimates?
 Try direct measure of corporate
profitability or dependence on external
finance

15. Theoretical model
 Robustness of cost distributions and
production technologies?
• Prob of innovation may be convex in S t
Uniform cost Convex if labor share
distribution is greater than 1/2

16. Model’s link to empirics
 Model assumes PPP, providing link between
ex rt and price surprise,
• P=S
 but empirics show result depends on changes
in real exchange rate
 Model requires unexpected price (ex rt)
changes: if workers expect deprec or apprec, it
would be built into wage contract

17. Model’s link to empirics
 Show evidence that nominal exchange rate appreciation
leads to significant rise in real labor costs and decline in
operating profits, or that appreciation leads to fall in
productivity
• Maybe other mechanism: fluctuations in operating profits due to
pricing to market
 Countries far from technological frontier may upgrade by
importing, so appreciation may improve liquidity and thus
productivity growth
 Balance sheet effects of appreciation could relax credit
constraints if net wealth is considered as collateral
 Private credit to GDP and output per worker are strongly
correlated, so are results on financial development proxy
for convergence relationship?
• Which interaction predominates if both included in regression?

18. Model
 Stabilizing role of flexible exchange rates
analyzes nominal ex rt and productivity
volatility using Taylor rule
• Reaction to productivity shock is not clear—how is it
assumed to affect the output gap?
• One for one passthrough is counter to evidence,
especially for developed countries, that the paper find
benefit from volatility
• Taylor rule may have forward looking component.
Prices may be stable despite nominal ex rt changes,
especially if noise in risk premium is temporary

19. Empirics (previous version)
 Higherlevels of regulation have negative
impact on growth as exchange rate is
more flexible
• Less flexible labor market, product markets
and entry  fixed
 Counters OCA theory – ex rt flexibility
substitutes for other types of flexibility in
adjusting to real shocks