Deindustrialization, Reindustrialization, and the Real Exchange Rate

This paper models an economy in which it is costly to move resources between the tradeable and nontradeable sectors. The economy is subject to capital flows that are unpredictable and are perceived as having only limited persistence. The model shows that both the fact that capital flows are perceived as temporary and uncertainty per se act to limit the responsivesness of resource reallocation to real exchange rate movements. In turn, this reluctance of factors to move widens the range of real exchange rate variation, so that larger movements of the real exchange rate are needed to accommodate transitory, unpredictable capital flows than would be required to accommodate persistent, predictable flows of the same magnitude. The model also shows that large capital inflows that lead to real exchange rate appreciation large enough to induce resource reallocation will typically be followed by a depreciation of the real exchange rate to below its original level.