The Nontradable Goods’ Real Exchange Rate Puzzle

Abstract

Real exchange rates are among the most volatile aggregate prices. The volatility of real exchange rates in a cross‐section of countries is typically a multiple of the volatility of output, and the deviations are highly persistent. As demonstrated by Engel (1999) and Betts and Kehoe (2001, 2006, 2008), the decomposition of real exchange rate movements in the data suggests that the bulk of these movements is accounted for by the international deviations of the relative price of tradable goods—the so‐ called tradable component of the real exchange rate decomposition. This finding is grossly at odds with the predictions of the traditional theories of real exchange rate determination featuring one homogeneous tradable good for which the law of one price holds and distinct nontradable goods. Unlike in the data, in these theories, the real exchange rate is fully accounted for by the deviations of the relative price of nontradable goods across countries. However disturbing these empirical results are from the perspective of the traditional theories, they are not readily inconsistent with the predictions of the standard international macro models featuring differentiated tradable goods by the country of origin—like the Backus, Kehoe, andKydland (1995)model or the extension of thismodel due to Stockman and Tesar (1995). In this class of models, despite the fact that the law of one price is preserved at all times for individual tradable commodities, the tradable component of the real exchange rate can be volatile due to relative pricemovements of differentiated foreign and domestic varieties of tradable goods. Motivated by this state of affairs, our paper asks to what extent standard international macro theories can be consistent with the data. More precisely, we ask whether a carefully parameterized standard theory,