Traded Goods Consumption Smoothing and the Random Walk Behavior of the Real Exchange Rate

Conventional explanations of the near random walk behavior of real exchange rates rely on near random walk behavior in the underlying fundamentals (e.g., tastes and technology). The present paper offers an alternative rationale, based on a fixed factor neoclassical model with traded and nontraded goods. The basic idea is that with open capital markets, agents can smooth their consumption of tradeables in the face of transitory traded goods productivity shocks. Agents cannot smooth nontraded goods productivity shocks, but if these are relatively small (as is often argued to be the case) then traded goods consumption smoothing will lead to smoothing of the intra-temporal price of traded and nontraded goods. The (near) random walk implications of the model for the real exchange rate are in stark contrast to the empirical predictions of the classic Balassa-Samuelson model. The paper applies the model to the yen/dollar exchange rate over the floating rate period.