Yong Wang and Jenny Xu, Hong Kong University of Science and Technology, and Xiaodong Zhu, University of Toronto

 Structural Change and the Dynamics of China-U.S. Real Exchange Rate

 

Wang, Xu, and Zhu study the dynamics of the real exchange rate between China and the U.S. since 1990. The researchers first show that a standard Balassa-Samuelson model without structural change cannot account for the observed real exchange rate behavior. They then extend the Balassa-Samuelson framework to a three-sector model with structural change and show that the model can quantitatively account for both the structural changes in the two countries and the behavior of the real exchange rate. A key element of the model is frictions to labor reallocation across sectors. Between 2000 and 2010, the manufacturing sector's share of employment in China increased from 25 percent to 34 percent. The researchers argue that this is mainly driven by a decline in the frictions to labor reallocation from agriculture to manufacturing. Without the decline in labor frictions, the manufacturing sector's share of employment in China would have declined during this period and the real value of Renminbi would have appreciated more than what is observed in the data during the same period. The results highlights the important roles of labor market conditions and structural change in determining the dynamics of real exchange rate.