Productivity differentials, the relative price of non-tradables and real exchange rates

Abstract

This paper reconciles the apparent contradiction between recent panel unit root tests of real exchange rates and the productivity differential model, proposing an alternative view that explains the coexistence of such findings. Real exchange rates and the relative price of non-tradables reflect the gradual adjustment of mean-reverting and endogenously competing factors: supply and demand shocks as well as traded goods arbitrage. Granger causality and variance decomposition results indicate substantial simultaneity and feedback effects between real exchange rates, the relative price of non-tradables and productivity differentials.