Real exchange rate fluctuations, endogenous tradability and exchange rate regime

This paper, empirically and theoretically, studies variance decomposition of real exchange rate. We find that deviations from the law of one price for traded goods drive most real exchange rates. However, the relative price of nontraded goods is also important for some countries maintaining stable exchange rate. We propose an explanation based on dynamics of comparative advantage. Our model predicts that comovement of terms of trade and productivity differentials of the nontraded and the export sector raises importance of deviations from the law of one price. With interest rate shocks, exchange rate stability reduces the covariance and raises importance of the relative price of nontraded goods. Productivity shocks generate positive covariance and make deviations from the law of price play a dominant role, regardless of exchange rate flexibility.