Tradability of Goods and Real Exchange Rate Fluctuations

Abstract

ABSTRACT __________________________________________________________________________ We develop a simple, multicountry, multisector intertemporal general equilibrium model in which the de-gree of tradability of output differs across sectors. Tradability is determined both by the degree of substi-tutability in consumption between units of the same good produced in different countries and by the transactions costs that must be incurred to consume goods outside their country of origin. Home bias is endogenously determined. A vector of country specific shocks is realized at each data, and there are complete contingent claims markets. A calibrated version of the model replicates the observed relation-ship between movements in the bilateral real exchange rate between Mexico and the United States and movements in the relative price of comparatively nontraded goods to traded goods across countries. In addition, the shocks induce movements in trade balances and real exchange rate that are consistent with the data. Finally, the model can also match evidence on sectoral deviations from the law of one price. When the model is adapted to incorporate money as a medium of exchange, and there are no monetary nonneutralities, the same model is capable of replicating the observed relationship in our data between the real exchange rate and the nominal exchange rate.

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