Microeconomic sources of real exchange rate variation

Abstract

We provide a series of variance decompositions based on a panel data set of international goods prices. The panel spans 301 goods and services across 123 cities from 78 countries over the years 1990-2015. We analyze good-by-good deviations from the Law of One Price (LOP) for all bilateral city pairs and time periods. Our main finding is that variation within the LOP distribution is large relative to how the distribution itself moves over time. More specifically, we find that (i) long term deviations from LOP account for just as much of the overall price distribution as does time series variation around the long term LOP deviations, (ii) the cross good variance of the price distribution dwarfs movement in its mean, the equally-weighted real exchange rate, (iii) common variation in LOP deviations — such as that imparted by variation in nominal exchange rates — is small relative to good-specific variation, (iv) time series variation is larger for traded goods than for non-traded goods, whereas the opposite is true for cross-sectional variation, and (v) city and good-specific ‘fixed effects’ play an important role in describing how the moments of the price distribution vary in the cross section. We argue that these findings should inform research at the intersection of international macroeconomics and international trade.