The Roles of the Terms of Trade and Nontraded-Good-Prices in Exchange Rate Variations

This paper demonstrates that disturbances to supplies or demands for internationally traded goods affect exchange-rates differently than do disturbances in markets for nontraded goods. The paper develops a stochastic two-country equilibrium model of exchange rates, asset prices, and goods prices, with two internationally traded goods and a nontraded good in each country. Optimal portfolios differ across countries because of differences in consumption bundles. Changes in exchange-rates, asset prices, and goods prices occur in response to underlying disturbances to supplies and demands for goods. We examine the ways in which responses of the exchange-rate are related to parameters of tastes and production shares, and we discuss conditions under which these exchange-rate responses are "large" compared to the responses of ratios of nominal price indexes.