Understanding the Effect of Productivity Changes on International Relative Prices: The Role of News Shocks

International relative prices, including the real exchange rate and the terms of trade, are very important channels for the international transmission of country-specific shocks. Recent empirical studies find that the terms of trade and the real exchange rate of the US appreciate when US labor productivity increases. This finding is at odds with predictions from standard international macroeconomic models. In the proposed project, we study whether the anticipated component of productivity gains (known as news shocks) helps reconcile standard model predictions with the above empirical finding. We find that incorporating news shocks to total factor productivity (TFP) in an otherwise standard dynamic stochastic general equilibrium model with variable capital utilization can help the model replicate the appreciation of the real exchange rate following an increase in labor productivity documented in US data. We also empirically find that the US real exchange rate appreciates following a favorable news shock to TFP.