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Real Exchange Rate Fluctuations and Endogenous Tradability

Jan 2004
Working Paper
03-017
By  Kanda Naknoi
This paper examines, empirically and theoretically, the sectoral decomposition of the volatility of real exchange rates. For the purpose of this decomposition, goods are classified as being traded or nontraded in international markets. The first part performs an empirical analysis for a broad cross section of countries. The relative price of nontraded goods to traded goods is found to be relatively more important in movements of real exchange rates of the country pairs that maintain stable nominal exchange rates. The paper goes on to construct a model with endogenous tradability to suggest an explanation for the evidence. The key features of the model are heterogeneous productivity, transport costs, and sticky wages. The nontraded sector arises from non-zero trade costs. The relative price of goods depends on productivity, transport costs, and in the short run, on the exchange rate regime. The calibration shows that the relative price of nontraded goods makes a much greater contribution to overall real exchange rate volatility under a fixed exchange rate regime than a flexible regime, as in the data.