Real Exchange Rates and the Prices of Nontradable Goods


WP/94/19-EA

Real Exchange Rates and the Prices of Nontradable Goods
by Stefano Micossi and Gian Maria Milesi-Ferretti

Until September 1992, the European Monetary System (EMS) was
characterized by an appreciation of the real effective exchange rate in
higher inflation countries, such as Italy and Spain. EMS members have also
experienced very different dynamics in the relative price of tradable goods
in terms of nontradables, and in relative sectoral productivity.

This paper tries to provide a perspective on real exchange rate
developments after the inception of the EMS. It focuses on structural
determinants of real exchange rates, notably prices of tradables and non-
tradables, and productivity. The analysis shows that changes in the
relative price of tradable goods in terms of nontradables account for a
sizable fraction of real effective exchange rate dynamics until September
1992 in both Italy and Spain.

In accordance with theory, the study shows that sectoral productivity
growth differentials help explain the behavior of the relative price of
tradable goods, especially in the long run. There is also some evidence
that the EMS had an impact on relative price behavior.

Finally, productivity developments may also explain the divergent
behavior of real exchange rate indicators, such as those based on relative
value-added deflators and relative unit labor costs.