Nontradable Goods and the Real Exchange Rate

How important are nontradable goods and distribution costs to explain real exchange rate dynamics? We answer this question by estimating a general equilibrium model with intermediate and final tradable and nontradable goods. We find that the estimated model can match characteristics of the data that are relevant in international macroeconomics, such as real exchange rate persistence and volatility, and the correlation between the real exchange rate and other variables. The distinction between tradable and nontradable goods is key to understand real exchange rate fluctuations, but the introduction of distribution costs is not. Nontradable sector technology shocks explain about one third of real exchange rate volatility. We also show that, in order to explain the low correlation between the ratio of relative consumption and the real exchange rates across countries, demand shocks are necessary.