Temperature and Real Exchange Rates

Abstract

This study incorporates average temperature into the Balassa–Samuelson model to examine the impact of temperature differences on real exchange rates (RERs). It demonstrates that the classic Balassa–Samuelson model is a special case of a more generalized model. When average temperature differences reduce relative productivity with temperature effects, RERs tend to depreciate; otherwise, they appreciate. A cross-sectional analysis of 163 economies from 1980 to 2019 indicates a significant negative relationship between average temperature and the RER. If the average temperature in one economy is 0.19°C higher than that in another, its RER tends to depreciate by 5.75 percent to 6.01 percent. This effect is observable only when the average temperature exceeds 14°C or 15°C. The depreciation is more pronounced in wealthier or less agriculture-dependent economies.