Currency undervaluation and comparative advantage

This paper highlights a tradeoff implied by a policy of export-led growth through currency undervaluation. While undervaluation can foster domestic manufacturing in countries like China by sustaining trade surplus, it also can harm a country's comparative advantage by altering the composition of exports. Undervaluation may discourage specializing in high-value added manufacturing and instead favor specialization in non-differentiated goods with higher price elasticity. A dynamic general equilibrium model of two traded good sectors and capital account restrictions shows that undervaluation can either raise or lower welfare depending on two competing effects on comparative advantage: an elasticity effect versus an agglomeration effect working through firm entry and roundabout production.