Productivity Shocks and Real Effective Exchange Rates

• Date: 01 August 2015
• Author: Robert Czudaj,Ansgar Belke,Joscha Beckmann
• Published date: 01 August 2015
• DOI: http://doi.org/10.1111/rode.12165

Productivity Shocks and Real Effective

Exchange Rates

Joscha Beckmann, Ansgar Belke, and Robert Czudaj*

Abstract

This paper provides new insights into the relationship between exchange rates and productivity develop-

ments for European Economies. We focus on the question whether productivity changes have a long-run

impact on real effective exchange rates for a large number of European economies. Focusing on a sample

period running from 1995 until 2013, we adopt a cointegrated vector autoregressive approach and distin-

guish between long-run equilibrium, short-run dynamics and long-run impact of shocks. Our findings show

that for several industrialized economies, real effective exchange rates and labor productivity are not

related over the long-run. A possible explanation for this result is that wage developments do not reflect

increases in labor productivity to a large degree, which prevents a transmission to the real effective

exchange rate through the price channel. The results for Central and Eastern European Countries are more

encouraging since a positive impact of labor productivity on real effective exchange rate is frequently

observed.

1. Introduction

Since the breakdown of Bretton Woods, a large number of studies has focused on

long-run determinants of nominal exchange rates. Traditional determinants include

consumer prices and interest rates as suggested by the purchasing power parity and

the uncovered interest rate parity. When it comes to real exchange rates, productivity

shocks are supposed to be a long-run driving factor according to both the Balassa–

Samuelson hypothesis and New Open Economy Macroeconomic models. However,

convincing empirical evidence for such a relationship has yet to be provided. Many

studies have struggled to provide such a link but the overall findings suggest that

emerging economies’ exchange rates might be more frequently affected by productiv-

ity shocks (Strauss, 1996; Chinn and Johnston, 1997; Berka et al., 2012). In terms of a

currency union, an interesting question is whether real exchange rates are able to

adjust to shocks. Berka et al. (2012) find, in contrast to Friedman’s argument for flex-

ible exchange rates, that the real exchange rate behaves in line with theoretical con-

siderations for the Eurozone.

The aim of this paper is to provide new insights into the relationship between

exchange rates and productivity developments for European Economies. Previous

studies have analyzed this issue either for the ratio of prices for tradable to

nontradable goods according to the internal definition of the real exchange rate or for

* Beckmann: Department of Economics, University of Duisburg-Essen, 45117 Essen, Germany.

Tel: + 49-201-183-3215; Fax:+49-201-183-4181; E-mail: joscha.beckmann@uni-due.de. Also affiliated to Kiel

Institute for the World Economy. Belke: Department of Economics, University of Duisburg-Essen,

Germany. Also affiliated to CEPS, Brussels and IZA, Bonn. Czudaj: Department of Economics, University

of Duisburg-Essen, Germany. Also affiliated to FOM Hochschule für Oekonomie & Management, Univer-

sity of Applied Sciences, Essen, Germany. The authors would like to thank two anonymous referees as well

as participants of the International Conference “Exchange Rates, Monetary Policy and Financial Stability

in Emerging Markets and Developing Countries” (Leipzig, 2014) for very helpful comments.

Review of Development Economics, 19(3), 502–515, 2015

DOI:10.1111/rode.12165

© 2015 John Wiley & Sons Ltd