Remoteness and real exchange rate volatility

Abstract

This paper examines the impact of trade costs on real exchange rate volatility. The relationship is examined by constructing a two-country Ricardian model of trade, based on the work of Dornbusch, Fischer, and Samuelson (1977), which shows that higher trade costs result in a larger nontradables sector, in turn leading to higher real exchange rate volatility. We then construct a remoteness index to proxy for trade costs, and provide empirical evidence supporting the channel. © 2006 International Monetary Fund.