Which Accounts for Real Exchange Rate Fluctuations, Deviations from the Law of One Price or Relative Price of Nontraded Goods?

The literature on real exchange rate fluctuations is precisely divided by the views regarding their source. One emphasizes the relative price of nontraded goods to traded goods by assuming nominal rigidities in the nontraded sector or in the factor prices. The other stresses the importance of the traded component or the deviations from the law of one price. In this paper, we use Betts and Kehoe (2001)'s real exchange rate decomposition to explore which component accounts for the bilateral real exchange rate fluctuations among six East Asian countries and the United States. We find that a significant fraction of the variance of real exchange rates is accounted for by the deviations from the law of one price for traded goods, while the relative price of nontraded to traded goods also plays an important role as nominal exchange rate becomes stable.