The Effective Exchange Rate, Employment, and Growth in a Foreign Exchange Constrained Economy.

by Richard R. Nelson

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An analysis of how the effective exchange rate--the price of foreign exchange relative to domestic factor prices--influences the balance of payments constraint and, hence, Colombia's ability to achieve faster growth and higher employment. The conventional two-gap models lead to the pessimistic conclusion that Colombia cannot increase its growth rate without increases in foreign assistance and, therefore, that the level of the effective exchange rate is not of particular policy concern. A model is developed that admits the possibility of substituting domestic inputs for both intermediate and capital goods imports, demonstrating that Colombia has far more room to maneuver than the two-gap models suggest. The price of this maneuverability is an effective exchange rate. This, in turn, suggests that, since the fall in coffee prices, the target effective exchange rate may have been set too low, given Colombia's employment and growth objectives and reduction in foreign exchange supply. 65 pp.

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