Equilibrium real exchange rate, volatility, and stabilization

Abstract

This paper is composed of two parts. The theoretical part studies the effect of real exchange rate (RER) volatility on trade using a general equilibrium framework. The volatility of the RER is derived endogenously, and is caused by a demand shock, which may be influenced by inflation volatility. The model shows that RER volatility affects positively the equilibrium RER. In the empirical part, the behavior of several RER volatility indexes over the last fifteen years for Brazil is examined, identifying the influence of stabilization plans and inflation volatility. In fact, inflation volatility explains most of the variation in RER volatility in Brazil. In addition, export supply equations that include RER volatility as one of the explanatory variables are estimated for Brazil. For most specifications the RER volatility coefficient is negative, although not significantly different from zero. The implied elasticity for the most significant RER volatility coefficient is −0.05.