Tradability of Goods and Real Exchange Rate Fluctuations

_________________________________________________________________________ We develop a simple, multicountry, multisector intertemporal general equilibrium model in which the degree of tradability of output differs across sectors. Tradability is determined both by the degree of substitutability in consumption between units of the same good produced in different countries and by the transactions costs that must be incurred to consume goods outside their country of origin. Home bias is endogenously determined. A vector of country specific shocks is realized at each data, and there are complete contingent claims markets. A calibrated version of the model replicates the observed relationship between movements in the bilateral real exchange rate between Mexico and the United States and movements in the relative price of comparatively nontraded goods to traded goods across countries. In addition, the shocks induce movements in trade balances and real exchange rate that are consistent with the data. Finally, the model can also match evidence on sectoral deviations from the law of one price. When the model is adapted to incorporate money as a medium of exchange, and there are no monetary nonneutralities, the same model is capable of replicating the observed relationship in our data between the real exchange rate and the nominal exchange rate. _____________________________________________________________________________________ * 2001, Caroline M. Betts and Timothy J. Kehoe. We would like to thank Michele Boldrin, V.V. Chari, Charles Engel, Gonzalo Fernandez de Cordoba, Patrick Kehoe, Narayana Kocherlakata, David Levine, Robert Lucas, Victor Rios-Rull, Nancy Stokey, and seminar participants at numerous conferences and seminars for many valuable comments on earlier versions of this paper. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.