Nontraded Goods, Market Segmentation, and Exchange Rates

Empirical evidence suggests that international goods markets are highly segmented (even for traded goods). Nontraded goods, both in the form of final consumption goods and as an input into the production of final tradable goods, may be an important aspect of market segmentation across countries. In this paper we show that nontraded goods have important implications for exchange rate behavior, even though fluctuations in the relative price of nontraded goods account for a relatively small fraction of real exchange rate movements. In our quantitative study nontraded goods increase the volatility of exchange rates by about 40 percent or more when compared to the model without nontraded goods. Moreover, cross-country correlations and the correlation of exchange rates with other macro variables are closer in line with the data. In addition, contrary to a large literature, standard alternative assumptions about the currency in which firms price their goods are virtually inconsequential for the properties of aggregate variables in our model, other than the terms of trade