Real Exchange Rate, Productivity and Labor Market Rigidities

We extend the classic Balassa-Samuelson model to an environment with search unemployment. We show that the classic Balassa-Samuelson model with the assumption of full employment emerges as a special case of our more generalized model. In our generalized model, the degree of labor market rigidities affects the strength of the structural relationship between real exchange rate and sectoral productivity and in some circumstances, the standard Balassa-Samuelson effect may not hold. Empirical evidence supports our theory: controlling for the difference in labor market rigidities across countries provides a better fit in estimating the Balassa-Samuelson effect.