Understanding Real Exchange Rate Movements with Trade in Intermediate Products

David C. Parsley, OGSM, Vanderbilt University
Helen Popper, Santa Clara University - Department of Economics

Abstract

This paper reexamines decompositions of the real exchange rate that apportion its movements into a part that reflects international deviations from the law of one price and a part that reflects the relative prices of traded and nontraded goods within countries. Using Japanese and U.S. data, we first show that in such decompositions the traded/nontraded distinction is irrelevant at the consumer level. Next, motivated by a model of trade in intermediate products, we use implied import weights and find that relative traded/nontraded price changes, appropriately defined, can account for much of the real exchange rate's variation. These findings contrast sharply with earlier results that attribute real exchange rate movements to deviations in the law of one price; and, they provide fresh support for traditional real exchange rate models which rely on the distinction between the open and closed sectors of the economy.