Alternative theories of real exchange rate determination. A case study: The Mexican peso and the United States dollar

In almost any economy, developed or undeveloped, competitiveness has been fundamental to explain its ups and downs and the limits to its growth. This becomes particularly important in the current context of a free trade world. Competitiveness is viewed by conventional economic theory as associated with comparative advantages in trade, the exchange rate and its policy. In this dissertation, the measurement and determining factors of competitiveness are analyzed. The main proposition is that unit labor costs determine the real exchange rate in the long run and this, in turn, has important implications for policy.; The information of the Mexican and US manufacturing sectors for the period 1970–1995 is utilized to measure relative unit labor costs and test the proposition that the real exchange rate of the Mexican Peso with respect to the US Dollar is determined, in the long run, by the relative unit labor costs of manufacturing.; Despite the fact that unit labor costs are substantially lower in Mexico than in the US, mainly due to wage differentials, they increased relatively faster in Mexico than in the US in the period 1988–1994, due to the faster growth of productivity in the US. All of this resulted in a loss of relative competitiveness for Mexico, which was reflected in a growing trade deficit.; From the point of view of the unit labor costs approach a nominal depreciation has only a temporary and limited effect on competitiveness. A lasting improvement requires the use of more productive and cost reducing techniques. In the case of Mexico, differences in the level and the rate of change of productivity in manufacturing, with respect to the US, can be explained by the existing technological differences between the two countries. These differences persist whatever the exchange rate policy. They are always expressed in lower costs, and wage differentials cannot offset them completely and permanently. The opening of the Mexican economy made these differences show up more clearly with some rather dramatic results.