Equilibrium Exchange Rates and Supply-Side Performance

Bank of England Working Paper No. 156

39 Pages Posted: 11 Feb 2003

See all articles by Christoph Thoenissen

Christoph Thoenissen

University of St. Andrews - School of Management; Bank of England - Monetary Analysis

Gianluca Benigno

London School of Economics & Political Science (LSE) - Department of Economics; Federal Reserve Bank of New York

Date Written: June 2002

Abstract

This paper develops a two-country, optimising, sticky price model of real exchange rate determination in the 'new open macroeconomics' tradition which allows several different forms of deviation from purchasing power parity (PPP), both along the adjustment path and in the steady state. The model has a rich structure, and is designed to provide a flexible tool for policy analysis. Unlike most other papers in the literature, both of the key components of the real exchange rate - the relative price of non-tradables, and the terms of trade - are made endogenous, allowing a more complete analysis of the impact of structural shocks. To illustrate one possible application, the model is calibrated to match key elements of the UK and euro-area economies, and used to examine the extent to which possible improvements in the United Kingdom's relative supply-side performance might account for the sharp and persistent appreciation in sterling since 1996. The results are not supportive of this hypothesis. In the model, improvements in productivity, goods market and labour market competitiveness are all associated with a depreciation in both the spot and the equilibrium real sterling exchange rates. Two potential supply-side sources of an equilibrium appreciation - a productivity improvement biased towards traded goods (Balassa-Samuelson effect), and an anticipated future productivity rise - are considered; however, each is insufficient to account for a long-run equilibrium appreciation; the latter may account for an initial appreciation of the real exchange rate. We conclude by considering further mechanisms that could affect our results.

Keywords: Real exchange rates, PPP, monopolistic competition

JEL Classification: E52, F41

Suggested Citation

Thoenissen, Christoph and Benigno, Gianluca, Equilibrium Exchange Rates and Supply-Side Performance (June 2002). Bank of England Working Paper No. 156, Available at SSRN: https://ssrn.com/abstract=340460 or http://dx.doi.org/10.2139/ssrn.340460

Christoph Thoenissen (Contact Author)

University of St. Andrews - School of Management ( email )

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Gianluca Benigno

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