Equilibrium exchange rates and supply-side performance

Abstract

A two-country, optimising, sticky price model of real exchange rate determination in the new open macroeconomics tradition is developed, allowing several different forms of deviation from purchasing power parity (PPP), both along the adjustment path and in the steady state. The model has a rich structure, and is designed to provide a flexible tool for policy analysis. Unlike much of the literature, both of the key components of the real exchange rate-the relative price of non-tradables, and the terms of trade-are made endogenous, allowing a more complete analysis of the impact of structural shocks. To illustrate one possible application, the model is calibrated to match key elements of the UK and euro-area economies, and used to examine the extent to which possible improvements in the United Kingdom's relative supply-side performance might account for the sharp and persistent appreciation in sterling since 1996. The results are not supportive of this hypothesis. In the model, improvements in productivity, goods market and labour market competitiveness are all associated with a depreciation in both the spot and the equilibrium real sterling exchange rates. Two potential supply-side sources of an equilibrium appreciation are considered: a productivity improvement biased towards traded goods (Balassa-Samuelson effect); and an anticipated future productivity rise. However, each is insufficient to account for a long-run equilibrium appreciation, although the latter may account for an initial appreciation of the real exchange rate. The paper is concluded by considering further mechanisms that could affect the results.