Real Frictions and Real Exchange Rate Dynamics: The Roles of Distribution Service and Transaction Cost

Abstract

The fact that fluctuations in real exchange rates are highly volatile and persistent has been the central puzzle in international macroeconomics. This paper studies the role of real frictions in accounting for the puzzling behavior of real exchange rates. We show that the introduction of distribution costs and nontradable goods in an otherwise standard competitive model dramatically improves its ability to rationalize observed real exchange rate dynamics. We view our framework as complementary to those that emphasize the role of nominal rigidities.