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

Inkoo LEE
Jonghyup SHIN
KIEP Working Paper 08-06
JEL codes: 
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.