Disaggregating Real Exchange Rate Dynamics: A Structural Approach

This paper employs a small open economy DSGE model, estimated over 1986- 2009, to decompose the dynamic influence of domestic and international prices on the Canada-US real exchange rate. While the real exchange rate mimics the dynamic behavior of the relative price of non-tradables in terms of tradables in response to a non-tradable sector-specific disturbance, the purely tradable component dominates in the case of other shocks, irrespective of their structural origin. Variance decom- positions reveal that the sources of the movements in the tradable component lie in unsystematic deviations from uncovered interest parity as well as import price mark-up shocks. Consequently, these disturbances are far more potent than internal tradable or non-tradable sector-specific disturbances in driving real exchange rate .fluctuations.