Sectoral Productivity and Real Exchange Rate Appreciation: Much Ado about Nothing?

Using panel data for selected national economies, we estimate relative price changes stemming from fluctuations in sectoral productivity. Subsequently, we calculate the cross-country CPI-inflation differentials implied by sectorally unbalanced productivity growth, taking into account country-specific weights of nontradables in consumption (value added) and assuming there are no adjustments in nominal exchange rates. We find that sectoral productivity developments have a statistically significant impact on relative prices in the EU countries and also in the Czech Republic, but the magnitude of the impact is not as strong as the Balassa-Samuelson Effect (BSEF) would predict. The final impact of relative productivity on inflation (on the real exchange rate) is even weaker and, moreover, in the case of the Czech Republic the impact is negligible. Thus, contrary to the prevailing view, we question the meaning of the BSEF as a plausible explanatory variable of (equilibrium) real exchange rate determination in the Czech Republic. The same situation we simulate for the future, provided productivity growth in the traded sector does not accelerate dramatically.