TAILIEUCHUNG - WORKING PAPER NO. 06-9 NONTRADED GOODS, MARKET SEGMENTATION, AND EXCHANGE RATES

Empirical evidence suggests that movements in international relative prices (such as the real exchange rate) are large and persistent. Nontraded goods, both in the form of ¯nal consumption goods and as an input into the production of ¯- nal tradable goods, are an important aspect behind international relative price movements. In this paper we show that nontraded goods have important impli- cations for exchange rate behavior, even though °uctuations in the relative price of nontraded goods account for a relatively small fraction of real exchange rate movements. In our quantitative study nontraded goods magnify the volatility of exchange rates when compared to the model without nontraded goods. Cross- country. | Working Papers Research Department WORKING PAPER NO. 06-9 NONTRADED GOODS MARKET SEGMENTATION AND EXCHANGE RATES Michael Dotsey Federal Reserve Bank of Philadelphia and Margarida Duarte Federal Reserve Bank of Richmond May 2006 Research Department Federal Reserve Bank of Philadelphia Ten Independence Mall Philadelphia PA 19106-1574 econ Nontraded Goods Market Segmentation and Exchange Rates Michael Dotsey Federal Reserve Bank of Philadelphia Margarida Duarte Federal Reserve Bank of Richmond May 2006 Abstract Empirical evidence suggests that movements in international relative prices such as the real exchange rate are large and persistent. Nontraded goods both in the form of final consumption goods and as an input into the production of final tradable goods are an important aspect behind international relative price movements. In this paper we show that nontraded goods have important implications for exchange rate behavior even though fluctuations in the relative price of nontraded goods account for a relatively small fraction of real exchange rate movements. In our quantitative study nontraded goods magnify the volatility of exchange rates when compared to the model without nontraded goods. Crosscountry correlations and the correlation of exchange rates with other macro variables are closer in line with the data. In addition contrary to a large literature standard alternative assumptions about the currency in which firms price their goods are virtually inconsequential for the properties of aggregate variables in our model other than the terms of trade. Keywords exchange rates nontraded goods incomplete asset markets. JEL classification F3 F41 We wish to thank Steve Meyer Leonard Nakamura and especially George Alessandria for very useful discussions. The views expressed in this article are those of the authors and do not necessarily represent those of the Federal Reserve Bank of Philadelphia the Federal Reserve Bank of Richmond or

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