Relative Labour Productivity and the Real Exchange Rate in the Long Run: Evidence for a Panel of OECD Countries

The Balassa-Samuelson model, which explains real exchange rate movements in terms of sectoral productivities, rests on two components. First, the model implies that the relative price of non-traded goods in each country should reflect the relative productivity of labour in the traded and non-traded goods sectors. Second, the model assumes that purchasing power parity (PPP) holds for traded goods in the long run. We test each of these implications using data from a panel of OECD countries. Our results suggest that the first of these two fits the data quite well. The evidence on purchasing power parity in traded goods is considerably less favourable. When we look at US dollar exchange rates, PPP does not appear to hold for traded goods, even in the long run. When we look at Deutsche Mark exchange rates, PPP appears to be a somewhat better characterization of traded goods prices.