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Real Exchange Rate Dynamics in the Presence of Nontraded Goods and Transaction Costs

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  • Inkoo LEE

    (Korea Institute for International Economic Policy)

  • Jonghyup SHIN
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    Abstract

    This paper studies the role of nontraded goods and transaction costs in accounting for the puzzling behavior of the real exchange rate. In particular, we develop a simple general equilibrium model and evaluate the quantitative performance of the model in replicating the dynamic properties of the real exchange rate. The simulation results show that introducing both the transaction costs and nontraded goods in an otherwise standard model dramatically improve its ability to rationalize observed real exchange rate dynamic properties. The benchmark model matches 95% of the persistence and 90% of the volatility of the real exchange rate. In addition, the sensitivity analysis shows that our model can rationalize more than 97% of both persistence and volatility of the real exchange rate. Our analysis suggests that the purchasing price parity puzzle can naturally arise in the presence of transaction costs and nontraded goods, even under the assumption of a flexible price market.

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    File URL: http://www.eaber.org/node/21964
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    Bibliographic Info

    Paper provided by East Asian Bureau of Economic Research in its series Finance Working Papers with number 21964.

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    Date of creation: Oct 2008
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    Handle: RePEc:eab:financ:21964

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    Related research

    Keywords: Real exchange rate; persistence; Volatility; nontraded goods; Transaction costs;

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    1. Mario J. Crucini & Mototsugu Shintani, 2002. "Persistence in Law-Of-One-Price Deviations: Evidence from Micro-Data," Vanderbilt University Department of Economics Working Papers, Vanderbilt University Department of Economics 0222, Vanderbilt University Department of Economics, revised Jul 2004.
    2. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, Elsevier, vol. 50(1), pages 215-244, February.
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