Examining the Effects of Productivity Shocks on Real Exchange Rate under Infinite Supply of Unskilled Labor

This project presents an equilibrium model with nontradable goods, abundant supply of unskilled labour, and possibly purchasing power parity (PPP) deviations to analyze the effects of productivity shocks on real exchange rate (RER).The objective is to provide an equilibrium explanation for RER depreciation in China during the last few decades. Specifically, the investigators formalize Rogoff’s argument by extending Balassa-Samuelson’s model to an equilibrium model with infinite supply of unskilled labour and possibly PPP deviations. The extended model has the potential to (1) explain the persistent depreciation of the RMB in most of the periods in 1979 to 2004, and (2) reconcile the prediction of the Balassa-Samuelson productivity-based model with the RER movements of China by relaxing the full employment and PPP assumptions. The theoretical framework of the extended Balassa-Samuelson model is very general and is not limited to the case of China. The model can be applied to other large developing countries that share similar features to China in the labour market.