THREE ESSAYS ON EXCHANGE RATES, STRUCTURAL CHANGE, AND INVESTMENT

Abstract

This dissertation comprises three essays, each exploring distinct aspects of exchange rates and their economic implications.The first chapter investigates the impact of exchange rate misalignment on structural transformation, broadly defined as the process of reallocating labor from low- to high-productivity sectors, which serves as a mechanism for economic growth. Utilizing data from the GGDC 10-sector and ETD 12-sector databases, as well as UNIDO's 23 manufacturing sectors (classified into three technology-based categories), we explore whether exchange rate misalignment indices contribute to structural change and, consequently, economic growth. Our findings indicate that undervaluation does not appear to play a critical role in promoting growth-enhancing structural change. The results are inconsistent across various misalignment estimation techniques and different model specifications. The second chapter examines the impact of changes in industry-specific effective real exchange rates (IERER) on industry-level investment. We analyze how variations in industry-specific export intensity and import competition influence the long-run relationship between exchange rates and investment. Our analysis is based on data from 12 manufacturing industries across five European countries—Germany, Italy, the Netherlands, Norway, and the United Kingdom—covering the period from 2007 to 2017. The results indicate that in industries with low export intensity, a depreciation in IERER (i.e. an increase in price competitiveness) leads to a decline in investment. However, for industries with high export intensity, we find no significant effect from IERER depreciation, suggesting that industries heavily engaged in exporting do not reduce their investment levels following a depreciation in IERER. Additionally, we find that variations in import competition do not substantially alter the impact of exchange rate fluctuations on investment decisions. Finally, the third chapter revisits the issue regarding the uncovered interest rate parity (UIP) puzzle and the associated excess average returns of currency carry trade strategies. The UIP puzzle, which posits that interest rate differentials should be balanced by exchange rate movements, is contradicted by empirical evidence. This discrepancy has led to the widespread adoption of currency carry trade strategies in financial markets. Our investigation focuses on identifying key variables that contribute to UIP violations. We propose a novel regime-switching model with time-varying transition probabilities, integrating variable selection using the horseshoe prior to choose relevant factors from eight macroeconomic variables. Our findings reveal three major predictors—TED spread, term spread, and consumption growth of the U.S. economy—as significant predictors affecting regime shifts within the UIP puzzle.