Real Exchange Rates, Income per Capita, and Sectoral Input Shares

Aggregate price levels are positively related to GDP per capita across countries. We propose a mechanism that rationalizes this observation through sectorial differences in intermediate input shares. As aggregate productivity and income grow, so do wages relative to intermediate input prices, which increases the relative price of non-tradables if tradable sectors use intermediate inputs more intensively. We show that sectorial differences in intermediate input shares can account for two thirds of the observed elasticity of the aggregate price level with respect to GDP per capita. The mechanism has stark implications for industry-level real exchange rates that are strongly supported by the data.