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.

Appendix

Two-Country Real Exchange Rate Volatility

The variance of the real exchange rate can be expressed as follows:

$$\begin{array}{*{20}c}{{\rm{Var}}\left\{ {\log \left({{P \over {P\ast}}} \right)} \right\} = {\rm{Var}}\left\{ {\int\nolimits_{{z^F}}^{{z^H}} {\log } {{\left({{{{w_1} \cdot a(z)} \over {w_1^\ast \cdot a\ast(z)}} \cdot {{\exp (\varepsilon)} \over {\exp (\varepsilon \ast)}}} \right)}_{TB = 0}}dz} \right\}} \\ {\quad \quad \quad = {\rm{Var}}\left\{ {\int\nolimits_{{z^F}}^{{z^H}} {\log } {{\left({{{{w_1} \cdot a(z)} \over {w_1^\ast \cdot a\ast(z)}}} \right)}_{TB = 0}}dz} \right\}} \\ { + {\rm{Var}}\left\{ {\int\nolimits_{{z^F}}^{{z^H}} {\log } \left({{{\exp (\varepsilon)} \over {\exp (\varepsilon \ast)}}} \right)dz} \right\}} \\ { = {\rm{Var}}\left\{ {\int\nolimits_{{z^F}}^{{z^H}} {(\varepsilon - \varepsilon \ast)dz} } \right\}\quad \quad \;\;} \\ { = 2{{({z^H} - {z^F})}^2}{\sigma ^2},\quad \quad \quad \quad \;\;} \\ \end{array} $$

(A1)

where we have used the fact that only e and ε* are stochastic and that z^F and z^H remain fixed after shocks are realized.