The real exchange rate and quality improvements

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 10 April 2007

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.

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