Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Remittances, Exchange Rate Regimes, and the Dutch Disease: A Panel Data Analysis

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Remittances, Exchange Rate Regimes, and the Dutch Disease: A Panel Data Analysis

Article excerpt

Working Paper 2008-12

March 2008

Abstract: Using disaggregated sectorial data, this study shows that rising levels of remittances have spending effects that lead to real exchange rate appreciation and resource movement effects that favor the nontradable sector at the expense of tradable goods production. These characteristics are two aspects of the phenomenon known as Dutch disease. The results further indicate that these effects operate more strongly under fixed nominal exchange rate regimes.

JEL classification: F24, F31, O10

Key words: Dutch disease, real exchange rate, exchange rate regimes, remittances, panel data, system generalized method of moments

1 Introduction

International migrant remittances have increased significantly over the last two decades. Remittances received by developing countries, estimated at $221 billion in 2006, increased by 132% compared with 2001 figures, and currently represent 1.9% of total income in emerging economies (World Bank, 2008). Remittances are becoming increasingly important as a source of foreign income in terms of both magnitude and growth rate, exceeding the inflow of foreign aid and private capital in many countries. They currently represent about one-third of total financial flows to the developing world.

While some studies have provided evidence that high remittances are associated with lower poverty indicators and high growth rates (Adams and Page, 2005; Acosta et al, 2008), some concerns have emerged that rising levels of remittances, as any other massive capital inflow, can appreciate the real exchange rate in recipient economies (Amuedo-Dorantes and Pozo, 2004; Lopez et al, 2007), and therefore generate a resource allocation from the tradable to the nontradable sector (Acosta et al, 2007). This phenomenon is usually labeled as the 'Dutch disease'. Rodrik (2007) provides evidence that real exchange rate overvaluation undermines long-term economic growth, particularly for developing countries, in that in those countries tradable goods production suffers disproportionately from weak institutions and market failures. This underscores the importance of the implications of remittances for real exchange rate movements.

Different from previous studies, we study Dutch disease effects of remittances by estimating an equation that specifies the ratio of tradable-to-nontradable output as the dependent variable, in addition to the standard equation that has the real exchange rate as the regressand. This helps capture resource movement effect, i.e. the effect of remittances on the productive sector of the economy. Conventionally, the real exchange rate has been used because real appreciation serves as a summary indicator for the presence of Dutch disease effects. Nevertheless, given the absence of disaggregated data, it is difficult to disentangle nominal exchange rate effects on the real exchange rate. The introduction of tradable-to-nontradable output ratio and sectorial output shares (agricultural, manufacturing and services) as dependent variables provides an alternative method to empirical analysis of Dutch disease effects of remittances. Arguably, this may be considered a more accurate approach as we are better able to capture what may be thought of as purely 'real' effects of the Dutch disease phenomenon following an inflow of remittances. (1)

An additional contribution is that we test whether spending and resource movement effects of remittances are different under alternative exchange rate regimes. As discussed in Rodrik (2007), real exchange rate fluctuations are in principle the result of changes in real quantities only. However, the presence of nominal rigidities implies that exchange rate policies can affect real quantities. For instance, Levy-Yeyati and Sturzenegger (2005) use data for 179 countries to show that policy interventions of exchange rate markets affect the real exchange rate in the short to medium term. …

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