Traditional theory attributes fluctuations in real exchange rates to changes in the relative price of nontraded goods. This paper studies the relation between the United States' bilateral real exchange rate and the associated bilateral relative price of nontraded goods for five of its most important trade relationships. We find that this relation depends crucially on the choice of price series used to measure relative prices and on the choice of trade partner. The relation is stronger when we measure relative prices using producer prices rather than consumer prices. The relation is stronger the more important is the trade relationship between the United States and a trade partner. Even in cases where there is a strong relation between the real exchange rate and the relative price of nontraded goods, however, a large fraction of real exchange rate fluctuations is due to deviations from the law of one price for traded goods.
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The first version of this paper was circulated in February 2003. The authors gratefully acknowledge the financial support of the National Science Foundation. We would like to thank David Backus, Rudolfs Bems, Paul Bergin, Mario Crucini, Mick Devereux, Charles Engel, Gonzalo Fernández de Córdoba, Patrick Kehoe, Kristian Jönsson, Beverly Lapham, seminar participants at the Federal Reserve Bank of Minneapolis, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, NYU, Stanford, UC-Davis, UCLA, the University of Kansas, USC, the 2001 Annual Meeting of the Society for Economic Dynamics, the 2003 Workshop of the Jornadas Béticas de Macroeconomía Dinámica, and two anonymous referees for very helpful comments and suggestions. We also thank Jim MacGee, Ananth Ramanarayanan, and Kim Ruhl for extraordinary research assistance. The data used in this paper are available at http://www.econ.umn.edu/~tkehoe , and at http://www-rcf.usc.edu/~cbetts . The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
Copyright 2006 Elsevier B.V., All rights reserved.
- Real exchange rates
- Relative prices
- Trade relations