Real Exchange Rate Volatility and the Price of Nontradable Goods in Economies Prone to Sudden Stops

Abstract

The dominant view in the empirical literature on exchange rates is that the high variability of real exchange rates is due to movements in exchange-rate-adjusted prices of tradable goods. This paper shows that this dominant view does not hold in Mexican data for the periods in which the country had managed exchange rate regimes. Variance analysis of a thirty-year sample of monthly data shows that movements in the price of nontradables relative to tradables account for up to 70 percent of the variability of the real exchange rate during these periods. The paper presents a model in which this stylized fact, together with the sudden stops that accompanied the collapse of Mexico's managed exchange rates, could result from an endogenous amplification mechanism operating via nontradables prices in economies with dollarized liabilities and credit constraints. The key feature of this mechanism is Irving Fisher's debt-deflation process.