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

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Published date	01 August 2018
Author	Deokwoo Nam,Jian Wang
Date	01 August 2018
DOI	http://doi.org/10.1111/1468-0106.12200

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UNDERSTANDING THE EFFECT OF PRODUCTIVITY

CHANGES ON INTERNATIONAL RELATIVE PRICES: THE

ROLE OF NEWS SHOCKS

DEOKWOO NAM Hanyang University

JIAN WANG*Chinese University of Hong Kong (Shenzhen)

Abstract. The US real exchange rate and terms of trade have been found to appreciate when US

labour 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 open-economy sticky-price

dynamic stochastic general equilibrium (DSGE) model with variable capital utilization can help

the model replicate the above empirical ﬁnding. Labour 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 goods prices relative to foreign goods prices.

1. INTRODUCTION

Standard international macroeconomic models (e.g. Backus et al., 1994) predict

that a country’s terms of trade deteriorate when its productivity increases rela-

tive to the rest of the world. However, it has been documented that the US real

exchange rate and terms of trade appreciate rather than depreciate when the

country’s labour becomes more productive relative to other countries. In this

paper, we ﬁnd that incorporating news shocks to productivity in an otherwise

standard open-economy sticky-price dynamic stochastic general equilibrium

(DSGE) model can help the model replicate the above empirical ﬁnding.

International relative prices (measured by the terms of trade and the real

exchange rate) are very important channels for international transmissions of

country-speciﬁc shocks. Standard international macroeconomic models predict

that a country’s terms of trade deteriorate when its productivity of the tradable

goods sector increases relative to the rest of the world. In this case, productivity

gains in that country spill over positively to other countries through interna-

tional price adjustment, automatically insuring cross-country productivity un-

certainties. As a result, additional welfare gains from international risk sharing

*Address for Correspondence: Chinese University of Hong Kong (Shenzhen), School of Management

and Economics, Shenzhen, Guangdong Province, China. E-mail: jianwang@cuhk.edu.cn. We are

very grateful to the editor and two anonymous referees for many insightful comments. We thank

Mick Devereux, Charles Engel, Viktoria Hnatkovska, Ryo Jinnai, Enrique Martinez-Garcia, Akiko

Tarada-Hagiwara and seminar participants at the City University of Hong Kong, Dallas Fed,

Southern Methodist University, University of Colorado-Denver, Shanghai University of Finance

and Economics, Midwest Macro Meetings, Columbia-Tsinghua Conference of International Macro-

economics, and World Congress of Econometric Society for helpful comments. We would also like to

thank Janet Koech and Payton Odom for excellent research assistance. Deokwoo acknowledges sup-

port for this work from the National Research Foundation of Korea Grant funded by the Korean

Government (NRF-2014S1A5A8019024).

Paciﬁc Economic Review,••:•• (2017)

doi: 10.1111/1468-0106.12200

through ﬁnancial markets and policy coordination may be quite limited. For

instance, see Cole and Obstfeld (1991) and Obstfeld and Rogoff (2002).

However, focusing on US data, Corsetti et al. (2006, 2014), Enders and Muller

(2009) and Enders et al. (2011) document a robust appreciation of the terms of

trade and the real exchange rate after an increase in US labour productivity.

Several recent studies attempt to reconcile standard international macroeco-

nomic models with the above empirical ﬁndings. Corsetti et al. (2008) emphasize

the wealth effect of productivity gains when international ﬁnancial markets are

incomplete. A positive productivity shock in the home country has two effects.

First, it raises the home country’s output. Meanwhile, it increases the home

country’s wealth, and, therefore, its consumption, under incomplete interna-

tional ﬁnancial markets. If consumption is biased towards home goods, demand

for home goods increases more than demand for foreign goods. When the

increase in relative demand from the wealth effect is stronger than the increase

in relative output from productivity gains, home goods prices increase relative

to foreign goods prices. In particular, Corsetti et al. (2008) identify two cases

in which the wealth effect dominates the supply effect: (i) when the trade elastic-

ity is low, or (ii) when the productivity shock is very persistent and the trade elas-

ticity is sufﬁciently high. In both cases, the terms of trade and real exchange rate

appreciate following an increase in labour productivity in their model. Enders

and Muller (2009) ﬁnd similar results to those in Corsetti et al. (2008). In addi-

tion, they emphasize the importance of incomplete ﬁnancial markets in shaping

the dynamics of the terms of trade and trade balance following a country-speciﬁc

productivity shock. The international transmission of productivity gains can

also depend on the nature of the gains. Corsetti et al. (2007) consider two types

of productivity gains and their effects on the terms of trade. They show in their

model that the productivity gain that reduces the cost of producing existing

goods will deteriorate the terms of trade while the productivity gain that reduces

the cost of creating new ﬁrms and product varieties can improve the terms of

trade. This is because newly created ﬁrms produce and export high-price product

varieties, which increases the home country’s export prices relative to its import

prices.

This paper considers whether news shocks to TFP can help to replicate the

comovement of the real exchange rate and labour productivity as documented

in the US data. Our study is motivated by two observations. First, the news

shock to TFP has a similar wealth effect that is emphasized in Corsetti et al.

(2008). It may help to induce an appreciation of the real exchange rate following

a positive news shock to productivity. Second, news about future productivity is

an important driver of asset prices, including exchange rates, in the data.

Beaudry and Portier (2006) argue that asset prices are likely a good measure

of market expectations about future economic conditions. They identify news

shocks as innovations in stock prices, which are orthogonal to innovations in

some measures of productivity. Their identiﬁed news shocks predict productivity

several years into the future. Kurmann and Otrok (2013) ﬁnd that movements in

the slope of the term structure of interest rates mainly reﬂect the asset market’s

response to news about future productivity. In particular, Nam and Wang

D. NAM AND J. WANG2

Paciﬁc Economic Review

, 23: 3 (2018) pp. 490–516

doi:10.1111/1468-0106.12200