Real Exchange Rate Volatility and Economic Openness: Theory and Evidence

This paper relates the volatility of the (trade-weighted) effective real exchange rate to the degree of trade openness of an economy. The theoretical part presents an intertemporal monetary model with nominal labour (factor) market rigidities. Both monetary and aggregate supply shocks are shown to imply a (non-linear) inverse relationship between the import share of an economy and the volatility of its real exchange rate. Empirical evidence on a cross-section of 54 countries confirms this relationship: Difference in trade openness explain a large part of the cross-country variation in the volatility of the effective real exchange rate.