Title: Volatile and Persistent Exchange Rates: How Important are Distribution Costs?

Abstract

This paper studies the role played by distribution costs in shaping exchange rate behavior within a flexible price environment. Motivated by the empirical evidence that movements in real exchange rates are driven almost exclusively by changes in the prices of tradable goods, and that purchasing power parity does not hold for tradables, we assume, realistically, that transactions on tradable goods require a component of nontradable distribution services. This naturally drives a wedge between retail prices in different countries. And the wedge varies over time to the fluctuation of the nominal interest rate. We show that introducing distribution costs enables the model to generate volatile and persistent real exchange rates, the real and nominal exchange rate comovement, as well as positive correlations for output, employment, and investment across countries. It is also shown that distribution costs for imported goods are more important than those for domestically produced goods in the ability of accounting for exchange rates variations.