Working Paper No. 320
By Karen Dury and Özlem Oomen
This paper studies how the real exchange rate might respond to product innovation (improvements in the quality of goods) as opposed to process innovation (increased efficiency in the production of goods). We develop a two-country dynamic stochastic general equilibrium model, where quality improvements affect both the demand and the supply side of the economy. We show that the real exchange rate defined in terms of prices per quality unit (quality-adjusted prices) does not always move in the same direction as that defined in terms of unit prices (quality-unadjusted prices), illustrating the importance of measuring quality correctly.