Variety Supply versus Balassa-Samuelson Determinants of the Real Exchange Rate

This paper develops a model of long-run real exchange rates basedon a New Economic Geography framework that compares two determinantsof relative price levels. The first one is a standard Balassa-Samuelson mechanism, that explains relative prices in the non-tradedgood sector by productivity differentials. The second determinant,the "Variety Supply effect", explains PPP deviations in the tradedgood sector by the endogenous distribution of firms across countries.Calibrating the model with OECD data, one shows that the relativemagnitude of the Variety Supply effect is generally small and that botheffects can either play in opposite direction, or strengthen each other.This ambiguity is explained in a general equilibrium framework bythe sensitiveness of location decisions to the structure of preferences.When the share of traded good is large enough, the entry of firms leadsto a real depreciation because local consumers benefit from a trade costsaving. However, if the share of non-traded goods in consumption ishigh, this effect is more than compensated by a wage adjustment andthe real exchange rate appreciates.