Understanding Real Exchange Rate Movements with Trade in Intermediate Products
26 Pages Posted: 12 Aug 2006 Last revised: 25 Nov 2012
Date Written: February 9, 2009
We suggest it may be "too easy" to attribute real exchange rate movements to law of one price deviations. We show that it is immaterial whether one uses seemingly traded goods, nontraded goods, or even just a single, unimportant consumer good, say beer. The ease of attributing the variation to any such deviations is explained using a model with intermediate goods trade. In the model, the stage of production determines the traded/nontraded distinction. We find empirical substantiation for the model: law of one price deviations lose explanatory power; and - defined appropriately in terms of intermediate goods - relative prices matter.
Keywords: Real Exchange Rates, PPP, MSE decomposition
JEL Classification: F3, F4
Suggested Citation: Suggested Citation