Exchange Rate Economics: Theories and Evidence

76 The economics of the PPP puzzle
expression (2.12) dominates the behaviour of the overall real exchange rate: is it
movements in the relative price of traded goods (i.e. violations of the LOOP) or the
relative price of traded to non-traded goods? These tests were discussed in the last
chapter and,broadly speaking,are not supportive of the BS proposition since they
indicate that it is movements in the relative price of traded goods which,in large
measure,explain the time series behaviour of real exchange rates. However,these
indirect tests do not preclude a significant direct relationship between productivity
and exchange rate movements. The second set of tests rely on building measures
of productivity in the traded and non-traded sectors and regressing the CPI-based
real exchange rate and/or the internal price ratio onto these productivity measures.
3.2.3 Testing the Balassa–Samuelson proposition directly
using measures of productivity
In this section we consider some direct tests of the Balassa–Samuelson proposition.
Hsieh (1982),Marston (1990) and DeGregorio and Wolf (1994) examine the
relationship between the CPI-based real exchange rate and productivity in growth
terms. Results favourable to the Balassa–Samuelson hypothesis are reported,in the
sense that the coefficients on productivity in the two sectors are statistically significant
and correctly signed. 2 As Chinn and Johnston (1999) point out,however,the
use of growth rates in these papers allows for permanent shocks to the relationship
in levels,which is perhaps undesirable. Canzoneri et al. (1999) use panel cointegration
methods to test the relationship between the relative price of non-traded to
traded goods and relative productivity in the traded to non-traded sectors,where
productivity is measured using labour productivity differentials. Canzoneri et al.
report results supportive of the Balassa–Samuelson proposition,in the sense that
the relative price of non-traded to traded goods is cointegrated with productivity
differentials.
Ito et al. (1997) report a statistically significant relationship between the real
exchange rate change and the change in per capita GDP,their proxy for the
Balassa–Samuelson effect,for a group of Asian currencies. However,they do
not find an association between the per capita differential and the relative price
of non-traded to traded goods. As they recognise,one explanation for this latter
result could be that per capita GDP is not a good proxy for productivity differences.
Chinn and Johnston (1999) use OECD sectoral total factor productivity to analyse
the relationship between CPI-based real exchange rates and the relative price of
traded to non-traded goods and productivity differences. They report significant
cointegrating relationships,suggesting long-run relationships and point estimates,
which are supportive of the Balassa–Samuelson proposition. 3
MacDonald and Ricci (2001) also use the OECD sectoral data base to build
productivity measures which are then used in panel regressions of the CPI-based
real exchange rate. They find that when the difference between productivity in the
traded and non-traded sector is entered as a differential it is correctly signed,
strongly significant and has a plausible magnitude (in particular,they find a
point estimate on relative productivity of around 0.8,which is consistent with