Real Exchange Rates and Sectoral Productivity in the Eurozone

We investigate the link between real exchange rates and sectoral total factor productivity measures for countries in the Eurozone. We show that real exchange rate variation, both in cross-country and time series, closely accords withan amended Balassa-Samuelson interpretation, incorporating shocks both to sectoral productivity and a labor market wedge. We construct a sticky price dynamic general equilibrium model to generate a cross-section and time series of real exchange rates that can be directly compared to the data. Under the assumption of a common currency, estimates from simulated regressions are very similar to the empirical estimates for the Eurozone. Our findings contrast with previous studies that have found little relationship between productivity levels and the real exchange rate among high-income countries, but those studies have included country pairs which have a floating nominal exchange rate.