Trade Costs and Real Exchange Rate Volatility

This paper examines the impact of trade costs on real exchange rate volatil- ity. We model two channels endogenously in a Ricardian framework: (i) non- tradability and (ii) heterogeneous suppliers of traded goods. The ¯rst channel is examined by constructing a two-country Ricardian model of trade, based on the work of Dornbusch, Fischer and Samuelson (1977), which endogenizes the size of the nontradable sector. The model shows that higher trade costs result in a larger nontradable sector, which in turn leads to higher real ex- change rate volatility. The key mechanism underlying this result is that the price of nontraded goods will not adjust immediately across countries given a country-speci¯c shock. We provide evidence using a cross-country panel data set that tests for the impact of our channel as well as supporting three central predictions of the model. The second channel is examined by constructing a multi-country Ricardian model of trade with technological shocks, based on the work of Eaton and Kortum (2002), where real exchange rate volatilities will vary across countries because each country has a di®erent set suppliers of traded goods. This heterogeneity arises endogenously due to technological differences and trade costs. In this world, relative differences across countries is key. The model enables us to examine the impact of geopolitical forces (e.g., trade agreements) and trade costs on bilateral real exchange rate volatility, as well as exploring the impact of the variety of trade on exchange rate volatility empirically