Supply Shocks and Real Exchange Rate Volatility in a Small Open Economy

This paper examines the effect of overall and sector-specific productivity shocks on the real exchange rate in small open economies. A dynamic stochastic small open economy model shows that productivity shocks impact the real exchange rate mostly through changes in the relative price of non-traded goods and are unable to explain the large deviations from purchasing power parity for traded goods prices observed in the data. This paper also studies how the effect of productivity shocks on the real exchange rate changes when a country adopts a fixed exchange rate regime