We investigate the link between real exchange rates and sectoral TFP for eurozone countries. We show that real exchange rate variation, both cross-country and time-series, closely accords with an amended Balassa-Samuelson interpretation, incorporating sectoral productivity shocks and a labor market wedge. We construct a DSGE model to generate a cross section and time series of real exchange rates to compare to data. Estimates from simulated regressions are very similar to estimates for eurozone data. Our findings contrast with previous studies that have found little relationship between productivity and real exchange rates among high-income countries that have floating nominal exchange rates. (JEL E12, E23, E24, F31, F33, F43)

It is often suggested that currency unions unduly inhibit the efficient adjustment of real exchange rates. Recently, this has been seen as a key failure of the Eurozone. This paper presents evidence that throws doubt on this conclusion. Our evidence suggests that real exchange rate movement within the Eurozone was at least as compatible with efficient adjustment as the behavior of real exchange rates for the floating rate countries outside the Eurozone. This interpretation is consistent with a model in which nominal exchange rate movements give rise to persistent deviations from the law of one price in traded goods.