Heterogeneity of marginal shipping costs leads to persistent and volatile deviations in real exchange rate. In a two-country, three-good endowment general equilibrium model, arbitrage firms use transportation technology which depends positively on distance and physical mass of goods. The model exhibits endogenous tradability, non-linearity of law of one price deviations and trade-inducing and suppressing substitution effects due to heterogeneity in trade costs. When endowments follow an AR(1) process that matches comovement of US and EU GDPs and the aggregate trade costs consume 1.7% of GDP, real exchange rate persistence matches the data. A model with quadratic adjustment costs also induces substantial real exchange rate volatility.
- Arbitrage trade,
- real exchange rate,
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