Equilibrium exchange rates and supply-side performance

We develop a two-country, optimising, sticky prices and sticky wages model of real exchange rate determination in the new open macrocconomics tradition to analyse the interaction between supply-side behaviour, market structure and the real exchange rate. For a UK-euro area calibration, supply-side improvements to total factor productivity (TFP) or the degree of monopolistic competition in the goods and labour markets result in a depreciation of the real exchange rate. When TFP increases in the traded goods sector, a depreciation of the terms of trade offsets the appreciation of the relative price of non-traded goods, contrasting with the Balassa-Samuelson proposition.