Real exchange rate dynamics in New-Keynesian models - The Balassa-Samuelson mechanism revisited

This paper seeks to replicate the mechanism of the Balassa-Samuelson effect in a New Keynesian medium-scale DSGE model of a monetary union with traded and non-traded goods. A careful prior predictive analysis shows that a... [ view full abstract ]

This paper seeks to replicate the mechanism of the Balassa-Samuelson effect in a New Keynesian medium-scale DSGE model of a monetary union with traded and non-traded goods. A careful prior predictive analysis shows that a model with common wages and perfect labour mobility across sectors is insufficient as non traded goods prices will necessarily fall. Allowing for imperfect labour mobility across sectors and hence sector specific wages resolves this problem for the short- and medium-run. Both model versions feature a cushioning effect on changes in the real exchange rate coming from the terms of trade channel.