General Equilibrium Model of Arbitrage Trade and Real Exchange Rate Persistence

MPRA Paper from University Library of Munich, Germany

Abstract: Heterogeneity of marginal shipping costs leads to persistent and volatile deviations in real exchange rate. In a two-country, three-good endowment general equilibrium model, arbitrage firms use a transportation technology which depends positively on distance and physical mass of goods. The model exhibits endogenous tradability, non-linearity of law of one price deviations and trade-inducing and suppressing substitution effects due to heterogeneity in trade costs. When endowments follow an AR(1) process that matches quarterly HP-filtered US and EU GDPs, and the aggregate trade costs consume 1.7% of GDP, persistence of real exchange rate matches the data. A model with quadratic adjustment costs also induces sufficient real exchange rate volatility.

Keywords: Arbitrage trade; heterogeneity; real exchange rate; persistence; volatility (search for similar items in EconPapers)
JEL-codes: F3 F49 F41 F19 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-fmk, nep-ifn and nep-int
Date: 2005-08
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http://mpra.ub.uni-muenchen.de/234/ orginal version
http://mpra.ub.uni-muenchen.de/8608/ revised version

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