Skill-biased technological change and the real exchange rate

We sketch a model that shows how skill-biased technological change may reverse the classic Balassa-Samuelson effect, leading to a negative relationship between productivity in the tradable sector and the real exchange rate. In a small open economy, export goods are produced with high-skilled labor, in conjunction with capital and low-skilled labor, and are traded for imported consumption goods. Non-tradable services are produced with low-skilled labor only. A rise in the productivity of capital has two effects: (1) It may reduce the demand for labor in the tradable sector if the substitutability of low-skilled labor and capital in the tradable sector is high; and (2) it increases the demand for non-tradables and associated labor input. Overall demand for low-skilled labor declines if the labor force of the tradable sector is large relative to the labor force of the non-tradable sector. This leads to lower wages and thus to lower prices and real exchange rate depreciation.