The embodied real effective exchange rate: measuring cost competitiveness in global value chains

Abstract We propose the embodied real effective exchange rate (EREER), a measure of cost competitiveness at the country-sector level, accounting for global value chains. We derive it from a single Armington-CES framework with intermediate-input linkages. It departs in three respects from conventional REERs, which are predominantly constructed at the national level. First, it is constructed for individual country-sectors, each compared with the same sector abroad; indices for sectoral groups and entire economies follow by aggregation. Second, its deflator is the sector’s embodied unit labor costs, which incorporate labor-cost developments along the entire production chain at home and abroad, rather than in the sector alone. Third, its bilateral weights retain the double-weighting scheme of official REER statistics but are computed from the domestic value added in sectoral sales flows rather than from gross flows. Using global input–output data, we compare the EREER with conventional benchmarks at the sector level for German industries and at the country level for 36 economies. At the sector level, discrepancies are often large, and in some industries the measures even disagree on the direction of change; at the country level, they generally agree on the direction but differ in the magnitude and persistence of cumulative changes. In export regressions for country and sector panels, the estimated responsiveness to effective exchange rates is strongest under the EREER across export outcomes.