Working Paper

Understanding the effect of productivity changes on international relative prices: the role of news shocks

Abstract: The terms of trade and the real exchange rate of the US appreciate when the US labor productivity increases relative to the rest of the world. This finding is at odds with predictions from standard international macroeconomic models. In this paper, we find that incorporating news shocks to total factor productivity (TFP) in an otherwise standard dynamic stochastic general equilibrium (DSGE) model with variable capital utilization can help the model replicate the above empirical finding. Labor productivity increases in our model after a positive news shock to TFP because of an increase in capital utilization. Under some plausible calibrations, the wealth effect of good news about future productivity can increase domestic demand strongly and induce an increase in home prices relative to foreign prices.

Keywords: Business cycles - Econometric models; International finance; International trade - Econometric models; Labor productivity;

Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Globalization Institute Working Papers

Publication Date: 2010

Number: 61