General Equilibrium Model of Arbitrage Trade and Real Exchange Rate Persistence

Berka, Martin (2005): General Equilibrium Model of Arbitrage Trade and Real Exchange Rate Persistence.

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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Arbitrage trade; heterogeneity; real exchange rate; persistence; volatility
• Subjects: F - International Economics > F3 - International Finance; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F49 - Other; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics; F - International Economics > F1 - Trade > F19 - Other

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