Productivity and the Dollar/Euro Real Exchange Rate Over the 1985-2007 Period

Abstract

This paper examines the evidence for a productivity- based model of the dollar/euro real exchange rate for the period 1985-2007. Cointegrating relationships between the real exchange rate and productivity, real price of oil and government spending are estimated using the Johansen and Stock-Watson procedures. The findings show that each percentage point in the U.S.-Euro area productivity differential results in a three and one-half percentage point real change in the dollar/euro valuation. This finding is robust to the estimation methodology, the variables included in the regression, and the sample period. I 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.