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 of a small open economy with nominal rigidities. Both monetary and aggregate supply shocks are shown to produce (ceteris paribus) smaller real exchange rate movements if the country is more open to foreign trade. Empirical evidence on a cross section of forty-eight countries confirms this relationship: Differences in trade openness explain a large part of the cross-country variation in the volatility of the effective real exchange rate.