Published Book Review: Review of Radical Political Economy 32(3), Sept. 2000, 523-527.

Exchange Rate Parity for Trade and Development: Theory, Tests, and Case Studies.
Pan A. Yotopoulos.
Cambridge, UK: Cambridge University Press, 1996. 323 pp. +xvii, $54.95 hb.
Reviewed by: Alan G. Isaac, American University

Pan Yotopoulos is Professor of Economics at the Food Research Institute at Stanford University. He has written an ambitious book. The core argument is that incomplete markets are more pervasive and problematic in developing than in developed countries, that optimal policy therefore differs across countries, and that development successes can be explained by institutions that permit government to intervene in incomplete markets without generating excessive rent seeking. Yotopoulos wants to show that recent theories of incomplete markets justify a reformulation of optimal exchange-rate policy in developing countries. In contrast with the received wisdom, he argues that apparent exchange-rate overvaluation is often good for efficiency and for growth in developing countries. Conversely, free currency markets are argued to distort resource allocation in developing countries.

The book consists of three core projects: theoretical exposition, econometric tests, and case studies. The theoretical exposition is completely inadequate. The econometric tests are provocative. The case studies are quite interesting but inconclusive.

Although Yotopoulos refers often to theories of incomplete markets to undergird his controversial claims about the benefits of overvaluation, they play no role in his theoretical formalizations. Yotopoulos makes no claims to serious theoretical innovation. He primarily relies on static, mainstream models of a small open economy with fixed exchange rates. Specifically, he relies on the “Australian” model, which includes a nontraded goods sector, as presented by Dornbusch (1980) and Edwards (1989). His theoretical formalizations are small variations on the simplest static versions of this model. Perhaps because the Australian model is so well known, Yotopoulos truncates his presentation to the extent that it cannot serve as a useful introduction. Yet those already familiar with the model will be disappointed that Yotopoulos introduces dynamics only as extremely casual heuristics and completely avoids formalization of his most interesting theoretical claims. This is unfortunate, for given his goal of overturning conventional wisdom, he needs to carefully and rigorously expound his theoretical points.

The Australian model as presented by Yotopoulos simply cannot do the work to which he applies it. He presents a static model, yet he is interested in dynamics. He offers a model with no explicit consumers or classes, yet he wants to discuss welfare as well as efficiency issues. He refers constantly to the importance of incomplete markets, yet he never offers an explicit model of the market incompleteness that interests him. Finally, he almost completely neglects the monetary sector, which is nothing short of bizarre in a book that discusses nominal exchange rate determination. The reader is forced to conclude that theoretical development of his points was not the author's primary interest.

The empirical work offers a sharp contrast to the theoretical sections. Yotopoulos offers an unusually detailed discussion of the problems that arise in matching theoretical variables with actual data series. He offers a clear introduction to a variety of measures of the real exchange rate and of the “openness” of an economy. He includes extremely helpful discussions of the construction of his key data series–including the divisions into traded and nontraded goods that underlie his real exchange rate series. Finally, he offers an unusually frank characterization of his econometric explorations, which helps the reader both to understand and evaluate them.

Yotopoulos's core econometric finding is that the real exchange rate–defined as the price of tradables relative to nontradables–is negatively correlated with the growth rate of income as well as with the level of income. Yotopoulos argues that undervaluation causes slower growth. Additionally, Yotopoulos finds that openness reduces growth (inward looking strategies are more successful), that rising inflation is negatively correlated with growth, and that nominal devaluations have only partial and short-lived effects on the real exchange rate.

Two of Yotopoulos's conclusions are clearly controversial. His conclusion that openness is a negative for growth will produce many skeptics. His primary contention that real exchange rate undervaluation is an important stricture for growth will prove even more controversial. (Note that this is much stronger than the claim that devaluation can be contractionary, as argued by Edwards (1989).) For example, the reader may speculate that Yotopoulos finds a negative correlation between the real exchange rate and growth due to the well known negative correlation between the real exchange rate and the level of development (which Yotopoulos calls the Ricardo Principle) and a positive correlation in his sample between the level of development and growth. Yotopoulos certainly does not overlook the possibility that he is misinterpreting these correlations as causal relationships. Indeed, he offers econometric tests supporting his view of the causality. He thereby issues a provocative challenge to conventional wisdom, which can only be answered by empirical work which supports the conventional wisdom and explains Yotopoulos's results.

In addition to his econometric work, Yotopoulos supports his case with a sequence of short case studies. He begins with Japan, arguing that prescient, inward looking government intervention and institutions that limited rent seeking combined to produce the “miracle” of Japan's development. Yotopoulos argues that Japan's early industrialization was extremely inward looking, and that it was supported by an apparently overvalued exchange rate. Yotopoulos recognizes that there is no consensus on the equilibrium value of the Japanese exchange rate, and he simply sides with the overvaluation crowd after a very brief literature survey. Yotopoulos's downplaying of the role of export markets and his view that agricultural protection along with wage and income policies were key to assuring growth by maintaining domestic demand will prove controversial. Less controversial will be his general contention that growth was fostered by the specific features of Japan's institutions that ensured that rising consumption was supported by high domestic investment.

Yotopoulos picks the Philippines for his case study of a development failure. The Philippines is particularly interesting, since it looked so promising from the end of World War II to the time of the second oil price shock. Yotopoulos gives an eclectic account of the subsequent failure of development in the Philippines, drawing on the failure of land reform, the lack of infrastructure, and a lack of domestic demand (deriving from polarization of the income distribution and over-extraction of surplus from the agricultural sector). In the context of this book, the most important suggestion is that undervaluation of the Philippine peso proved an important barrier to growth. This however is little more than a suggestion, and Yotopoulos himself ends up placing much more stress on the lack of domestic demand for domestic manufactures.

Yotopoulos's final case study is a comparison of the development performance of Uruguay and Taiwan. In the 1960s the two countries had similar populations, per capital incomes, resource bases, and roles of agriculture. Since then their development performances have been startlingly divergent. In Yotopoulos's data, each had a persistently overvalued real exchange rate. He therefore openly concedes that the experience of Uruguay shows that overvaluation is not a sufficient condition for development. He then documents many differences in the two countries' development histories. Yotopoulos is particularly interested in how Taiwan's egalitarian income distribution and rapidly rising agricultural productivity helped support domestic demand for domestic manufactures. Corresponding to this emphasis, and in contrast with the conventional view that Taiwan adopted an open-economy, free-trade growth strategy, he sees the roots of Taiwan's success as lying in successful import substitution policies. Uruguay, Yotopoulos argues, was hurt by premature liberalization, especially in the financial sector. Financial market liberalization, he claims, should be the last move in the sequence of development policies.

Since Yotopoulos sees his primary claim in this book to be that in developing countries free currency markets cause a systematic misallocation of resources (toward the tradables sector) and a depression of growth, the case studies he provides are a bit puzzling. They certainly do not provide strong support for this claim. If anything, these case studies trace the failure of development primarily to a failure of domestic demand to support the development of domestic manufacturing, which he attributes in turn to polarization in the distribution of income. This is an interesting theme, but it is largely decoupled from the book's theoretical and econometric expositions. In addition, these short case studies simply survey a broad collection of country specific macroeconomic policies and presume that these policies–especially interventions in employment, in trade, and in the foreign exchange market–are causally connected to overall economic performance. The problem with such presumptions is that while we can always produce a unique list of macroeconomic policies for any country, it is clear from the controversies in the growth literature that it remains difficult to correlate macroeconomic policy choices with economic growth across countries.

Exchange Rate Parity for Trade and Development is a provocative, interesting, and frustrating book. Economists desiring theoretical rigor will be particularly frustrated, since Yotopoulos's most provocative theoretical assertions remain completely undeveloped. Development economists interested in careful, heterodox empirical work will probably find the book most rewarding. The econometric sections marshal support for an unconventional positive growth contribution of real exchange rate overvaluation. The case studies suggest that growth is promoted by domestic policies which ensure an increasing demand for domestic manufactures among a broad base of domestic consumers. These are interesting and controversial claims, which deserve additional exploration.


Dornbusch, Rudiger. 1980. Open Economy Macroeconomics. New York: Basic Books.

Edwards, Sebastian. 1989. Real Exchange Rates, Devaluation, and Adjustment: Exchange Rate Policy in Developing Countries. Cambridge, MA: MIT Press.