Productivity shocks, the real exchange rate, and the euro puzzle

This paper utilizes a large country open economy intertemporal model to obtain the effects of alternative types of productivity shocks on the real exchange rate. It then explores the conditions under which the model is consistent with the large swings in the real value of the euro. The main theoretical conclusion is that the effect of a productivity shock on the real exchange rate can change signs, depending on whether the shock applies to the productivity of new capital or old (existing) capital. The growth accounting literature suggests that the underlying reason(s) for US productivity growth changed abruptly between the 1995-2001 and 2002-2004 intervals. In the earlier period increases in the productivity of new capital were relatively more important, while increases in the productivity of old capital completely dominated in the later period. Thus, the model appears to be consistent with the abrupt switch (from negative to positive) around 2002 in the correlation between the real value of the euro (vis-a-vis the dollar) and the US minus EU productivity growth differential. (C) 2008 Elsevier Ltd. All rights reserved.