Exchange rate determination in a model of pricing-to-market and nontradeables

The international macroeconomic literature attributes the nominal and real exchange rate volatility to two mechanisms. The first one, underlined by Betts and Devereux [1996], lays stress on the deviation from the law of one price due to Pricing-To-Market (PTM) behavior whereas the second mechanism, uncovered by Hau [2000], relies on the presence of non tradables. This paper provides an integrated model with PTM and non tradables. We show that both effects are deeply intertwined. Following an expansion in the relative money supplies, PTM increases exchange rate volatility especially in open economies. Similarly, non tradables magnifies the exchange rate depreciation providing that the law of one price holds for a large share of tradables. Finally, the model suggests that PTM is more important than non tradables in accounting for the high exchange rate volatility.