Deviations in real exchange rate levels in the OECD countries and their structural determinants

We establish the validity of an augmented Balassa-Samuelson theory in a panel of real exchange rate levels between 18 OECD countries accounting for nearly two-thirds of the world GDP between 1970 and 2012 using a unique dataset of levels of total factor productivity (TFP) by sector. Real exchange rates can be explained by relative sectoral TFP levels both across countries and over time in the direction predicted by Balassa-Samuelson hypothesis, especially after accounting for labour wedges. We show structural labour market differences such as union concentration measures are key in elucidating the Balassa-Samuelson mechanism, and discuss the differences in the roles they play in a currency union and in freely-floating exchange rate economies. Finally, we show that large average unexplained deviations in real exchange rate levels remain for many countries in our sample.