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Real Exchange Rate Volatility and the Price of Nontradables in Sudden-Stop-Prone Economies

  • Enrique G. Mendoza

The dominant view in the empirical literature on exchange rates is that the high variability of real exchange rates is due to movements in exchange-rate-adjusted prices of tradable goods. This paper shows that this dominant view does not hold in Mexican data for the periods in which the country had managed exchange rate regimes. Variance analysis of a 30-year sample of monthly data shows that movements in the price of nontradables relative to tradables account for up to 70 percent of the variability of the real exchange rate during these periods. The paper proposes a model in which this stylized fact, and the Sudden Stops that accompanied the collapse of Mexico's managed exchange rates, could result from an endogenous amplification mechanism operating via nontradables prices in economies with dollarized liabilities and credit constraints. The key feature of this mechanism is Irving Fisher's debt-deflation process. Numerical evaluation suggests that the Fisherian deflation effects on consumption, the current account, and relative prices dwarf those induced by the standard balance sheet effect typical of the Sudden Stops literature.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11691.

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Date of creation: Oct 2005
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Publication status: published as Mendoza, Enrique G. “Real Exchange Rate Volatility and the Price of Nontradables in Sudden-Stop-Prone Economies.” Economia 6, 1 (Fall 2005).
Handle: RePEc:nbr:nberwo:11691
Note: IFM
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  1. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2000. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," NBER Working Papers 7869, National Bureau of Economic Research, Inc.
  2. Cristina Arellano & Enrique G. Mendoza, 2002. "Credit Frictions and 'Sudden Stops' in Small Open Economies: An Equilibrium Business Cycle Framework for Emerging Markets Crises," NBER Working Papers 8880, National Bureau of Economic Research, Inc.
  3. Rogers, John H. & Jenkins, Michael, 1995. "Haircuts or hysteresis? Sources of movements in real exchange rates," Journal of International Economics, Elsevier, vol. 38(3-4), pages 339-360, May.
  4. Enrique G. Mendoza, 2001. "The benefits of dollarization when stabilization policy lacks credibility and financial markets are imperfect," Proceedings, Federal Reserve Bank of Cleveland, pages 440-481.
  5. Parsley, David C., 2007. "Accounting for real exchange rate changes in East Asia," Journal of International Money and Finance, Elsevier, vol. 26(8), pages 1355-1377, December.
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  8. Enrique G. Mendoza, 2000. "On the Instability of Variance Decompositions of the Real Exchange Rate across Exchange-Rate-Regimes: Evidence from Mexico and the United States," NBER Working Papers 7768, National Bureau of Economic Research, Inc.
  9. Mendoza, Enrique G, 1995. "The Terms of Trade, the Real Exchange Rate, and Economic Fluctuations," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(1), pages 101-37, February.
  10. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
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  12. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2001. "The external wealth of nations: measures of foreign assets and liabilities for industrial and developing countries," Journal of International Economics, Elsevier, vol. 55(2), pages 263-294, December.
  13. Kanda Naknoi, 2005. "Real Exchange Rate Fluctuations and Endogenous Tradability," 2005 Meeting Papers 857, Society for Economic Dynamics.
  14. Bernardino Adão & Isabel Horta Correia & Pedro Teles, 2006. "On the Relevance of Exchange Rate Regimes for Stabilization Policy," Working Papers w200616, Banco de Portugal, Economics and Research Department.
  15. Burstein, Ariel T. & Neves, Joao C. & Rebelo, Sergio, 2003. "Distribution costs and real exchange rate dynamics during exchange-rate-based stabilizations," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1189-1214, September.
  16. Pablo Andres Neumeyer & Martín Gonzalez Rozada, 2003. "The elasticity of Substitution in demand for Non tradable Goods in Latin America. Case Study: Argentina," Department of Economics Working Papers 027, Universidad Torcuato Di Tella.
  17. Baxter, M. & Stockman, A.C., 1988. "Business Cycles And The Exchange Rate System: Some International Evidence," RCER Working Papers 140, University of Rochester - Center for Economic Research (RCER).
  18. Mendoza, Enrique G. & Uribe, Martin, 2000. "Devaluation risk and the business-cycle implications of exchange-rate management," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 53(1), pages 239-296, December.
  19. Reinhart, Carmen & Ostry, Jonathan, 1991. "Private Saving and Terms of Trade Shocks," MPRA Paper 13716, University Library of Munich, Germany.
  20. Guillermo A. Calvo & Carlos A. Vegh, 1999. "Inflation Stabilization and BOP Crises in Developing Countries," NBER Working Papers 6925, National Bureau of Economic Research, Inc.
  21. Kanda Naknoi, 2005. "Real exchange rate fluctuations, endogenous tradability and exchange rate regime," International Finance 0509004, EconWPA, revised 07 Nov 2005.
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  23. Guillermo A. Calvo, 1998. "Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops," Journal of Applied Economics, Universidad del CEMA, vol. 0, pages 35-54, November.
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