Expanding Varieties in the Nontraded Goods Sector and the Real Exchange Rate Depreciation

This paper studies how the real exchange rate changes with economic growth. Although Devereux (1999) proves that endogenous growth in the distribution sector can cause exchange rate depreciation, MacDonald and Rucci (2005) empirically find that growth in the distribution sector significantly causes the exchange rate to appreciate. To resolve the discrepancy, we replace perfect competition with monopolistic competition in the nontraded goods sector. Although growth of the distribution sector may cause the currency to appreciate, the endogenous growth in the nontraded goods sector tends to cause the currency to depreciate, because the expanding varieties from monopolistic competition drive down the price index of nontraded goods. With reasonable structural parameters, the latter effect dominates, and the real exchange rate depreciates. An economy with a smaller elasticity of substitution between demand for different varieties of the nontraded goods or higher TFP growth in the nontraded goods sector is more likely to have real exchange rate depreciation.