Question

Please describe the impact of positive and negative productivity shocks on the foreign exchange rate?

(Hint: You can use PPP for this question)

Answer 1

A positive productivity shock leads to an increase in supply. Thus, the supply shifts to the right, and the economy will have falling prices. Now the purchasing power parity theory tells us that in order for two countries to have equilibrium exchange rates (equal purchasing power), a fall in prices in a country is accompanied by the appreciation of the currency. Thus, the country facing a positive productivity shock will see an appreciating currency.

Similarly, if there is a negative productivity shock, the supply falls, inflation rises and the country will face a depreciating currency.