How Do Remittances Affect the Real Exchange Rate? An Empirical Investigation

Growing remittance flows to emerging and developing economies may lead to real exchange rate appreciation and weaken their competitiveness. While the empirical literature finds mixed results about the relevance of this relationship, it does not delve into understanding the interplay of two crucial elements for policymakers—the exchange rate regime and the structure of the economy. Filling this gap in the literature, our paper examines how exchange rate regimes and the structure of the economy affect the impact of remittance flows on the real effective exchange rate (REER). Using data from a large sample of economies over 2008-21, we arrive at three key findings. First, REER overvaluation correlates positively with remittance flows under flexible exchange rate regimes. Once controlling for potential endogeneity in a dynamic panel and other variables determining exchange rate behavior, we find that countries with fixed exchange rate regimes also experience appreciation, albeit smaller and slower relative to countries under flexible regimes. Second, we find relatively larger REER appreciation effects for countries that have import-to-GDP ratios lower than the world median, and countries with remittances-to-GDP ratios higher than the world median. Third, for countries that receive relatively high remittances and import relatively less, the REER appreciates after a remittance shock, regardless of the exchange rate regime. The results are robust to alternative classifications, data sources, specifications and sample size.