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Two-thirds of the real exchange rate’s (RER) volatility occurs at low frequencies. We provide empirical evidence that links movements in the RER to changes in research and development spending and patents. A two-country real business cycle model with endogenous productivity and a gradual dissemination of ideas can rationalize these facts. Endogenous productivity alters RER dynamics by inducing (1) a persistent gap in productivity between countries and (2) a reallocation of resources towards research and development spending. The estimated full model effortlessly replicates the dynamic properties of the RER at all horizons without sacrificing the model’s fit along other dimensions.
