Summary:
After the collapse of the Bretton Woods system, the metal standard declined in favor of the fiduciary standard and currency crises sometimes occurred. In the international context, exchange rate pricing and maintaining exchange rate stability have always been topics of concern for academics, governments and central banks. Although the equilibrium exchange rate theory based on purchasing power parity plays an important role in exchange rate pricing, the real exchange rate is often not equal to one; the Balassa-Samuelson (B-S) effect provides a reasonable explanation for this. The B-S effect provides a new research perspective for real exchange rate changes. However, the model's strong assumptions are unlikely to be satisfied in developing countries, implying that relaxing these assumptions is one of the most important approaches of study in the B-S effect literature. Most studies only relax one of the assumptions of the B-S model. China does not conform to the status quo because of its deviation from the Law of One Price and the segmentation in its labor market. In this paper, we allow for both of these and construct an open economy partial equilibrium model to decompose the real exchange rate of the RMB. Our model includes the deviation from the Law of One Price in tradables and the segmentation in the labor market. We use data for service industry sub-sectors and manufacturing firms in China and the U.S. from 2004Q1 to 2016Q4 to conduct a grouped empirical analysis of the B-S effect for the real exchange rate of the RMB and its transmission channels. Our theoretical and empirical results suggest that(1) the B-S effect between China and the United States exists but the transmission channel of relative productivity affecting the price level by affecting relative wages, ultimately affecting the real exchange rate, is not signi ficant. (2) In addition to the traditional B-S effect transmission channel, we find that relative productivity affects the real exchange rate by affecting GDP, implying that productivity affects the real exchange rate by affecting the nominal GDP growth rate of both countries. (3) Industrial structure imbalances have caused the divergence between relative productivity and relative wages in China to a certain extent and the increase in relative wages has a negative (appreciation) effect on the RMB exchange rate. There are two main contributions of this paper. (1) We provide a comprehensive analysis of the B-S effect after relaxing assumptions from both the theoretical and empirical perspectives. In addition to verifying the existence of the traditional B-S effect and its transmission channel, we consider additional transmission channels of the B-S effect. (2) Deviating from the standard approach in the literature, we analyze service industry sub-sectors, paying more attention to industry heterogeneity, and find that industries with divergent wages and productivity in China are more in line with the B-S effect. Our findings have policy implications for China. Overall, the relative wages of the service and manufacturing industries in China are higher than those in the United States. China's relative productivity is both positive and negative, which means that China's non-tradable sector is more attractive to labor than its tradable one. We believe that this may be due to the distortion in China's industrial structure and because of other reasons that caused the deviation of relative wages and relative productivity in the service and manufacturing industries. To reduce this divergence, we need to unswervingly carry out supply-side structural reforms to improve labor productivity,realizing the coordinated development of high-end manufacturing and service industries. These reforms are needed to reverse the current distortion in the industrial structure and narrow the divergence in relative productivity and relative wages in the service and manufacturing industries.
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