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General Equilibrium Model of Arbitrage Trade and Real Exchange Rate Persistence

By Martin Berka

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.

Topics: F3 - International Finance, F49 - Other, F41 - Open Economy Macroeconomics, F19 - Other
Year: 2005
DOI identifier: 10.2139/ssrn.869191
OAI identifier: oai:mpra.ub.uni-muenchen.de:8608

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