Measurement matters: Productivity-adjusted weighted average relative price indices

Abstract

Commonly used trade-weighted real exchange rate indices are computed as indices-of-indices, and thus do not adequately account for growth in trade with developing countries. Weighted Average Relative Price (WARP) indices solve this problem but do not control for productivity differences, as developing countries are observed to have lower price levels via the Penn Effect. I remedy these problems in two ways. First I propose a Penn Effect productivity adjustment to Weighted Average Relative Price indices (P-WARP). Secondly, I introduce a Weighted Average Relative Unit Labor Cost index (WARULC) for manufacturing and show that this measure does a much better job predicting trade imbalances and declines in manufacturing employment than the IMF's Relative ULC measure created as an index-of-indices. The new series reveal that for many countries currently mired in liquidity traps, relative prices reached historic highs heading into the financial crisis of 2008. I document that in 2002 – during the surprisingly sudden collapse in US manufacturing – US relative prices had not been that overvalued relative to trading partners since the worst year of the Great Depression.