Productivity shocks and real exchange rates

Previous studies have concluded that productivity shocks have negligible effects on real exchange rate fluctuations. This paper shows that when long-run equilibrium relationships between real exchange rate levels and fundamental variables are taken into account, relative productivity shocks account for most of the long-run movements in the real exchange rates. This can be interpreted as empirical support for the Balassa (1964. Journal of Political Economy 72, 584–596) and Samuelson (1964. Review of Economics and Statistics 46, 145–154) model where differences in relative productivity is the main source of long-run deviations for purchasing power parity.