The Euro and the Productivity Puzzle : An Alternative Interpretation

This paper documents the evidence for a productivity based model of the Dollar/Euro real exchange rate over the 1985-2001 period. Cointegrating relationships between the real exchange rate and productivity, government spending and the real price of oil are estimated using the Johansen (1988) and Stock-Watson (1993) procedures. We find that each percentage point in the US-Euro area productivity differential results in a five percentage point real appreciation of the dollar. This finding is robust to the estimation methodology, the variables included in the regression, and the sample period. We conjecture that productivity-based models cannot explain the observed patterns with the standard set of assumptions, and describe cases in which the models can be reconciled with the observed data