Commodity currencies and the real exchange rate ☆ Stephen Tokarick ⁎ Research Department, Macroeconomic Studies Division, International Monetary Fund, Room 9-700J, 700 19th street, N.W., Washington D.C. 20431, United States ABSTRACT ARTICLE INFO Article history: Received 29 July 2006 Received in revised form 12 March 2008 Accepted 3 April 2008 Available online 11 April 2008 Keywords: Real exchange rate Terms of trade Nontraded goods Models JEL classification: F11 F31 This paper shows that a change in the terms of trade of a commodity-exporting country could cause the relative price of nontraded goods to rise or fall, depending on the strength of income and substitution effects. © 2008 International Monetary Fund. Published by Elsevier Inc. All rights reserved. 1. Introduction Recently, a literature has developed that explores the relation- ship between changes in the terms of trade of a commodity- exporting country and its real exchange rate (see in particular Cashin et al. (2004) hereinafter referred to as CCS and Chen and Rogoff (2003)). A key link in the relationship between changes in a country's terms of trade and its real exchange rate is how the change in the terms of trade affects the price of nontraded goods. The papers of CCS and Chen and Rogoff, however, use models that limit the response of the price of nontraded goods to changes in the terms of trade in that they do not allow changes in demand to play a role in affecting the price of nontraded goods. This is a crucial omission, since income effects that arise from changes in commod- ity prices play a key role in influencing the price of nontraded goods and ultimately the real exchange rate, as in models of the “Dutch Disease.” Also, in both models, a change in the terms of trade (a rise in the price of a country's export commodity) will cause the price of the nontraded good to change by a fixed proportion. The purpose of this paper is to demonstrate that in the context of a general model, an improvement in a country's terms of trade need not lead to a rise in the price of nontraded goods relative to the price of traded goods. The response of both the price of nontraded goods and the real exchange rate will depend on the magnitude of income and substitution effects. 2. Models used in the literature 2.1. Cashin, Cespedes, and Sahay CCS adopt a model of a small, open economy that produces two goods, a nontradeable good and an exportable good referred to as a “primary commodity.” The model also includes an imported good that is not produced domestically. CCS state that: (i) firms in each sector use only labor to produce each good; (ii) production is carried out by a constant returns to scale technology; and (iii) labor is perfectly mobile, ensuring that wages are equalized across all sectors. Constant returns to scale implies that the price of each good must equal average cost: P E ¼ wb E ð1Þ and P N ¼ wb N ð2Þ where P j is the price of each good (the subscript E refers to the export good, N to the nontraded good), w is the wage rate (common to both sectors), and b j is the amount of labor required to produce a unit of good j. 1 Assuming that the price of the export good is given Economics Letters 101 (2008) 60–62 ☆ The views expressed in this paper are those of the author and should not be attributed to the International Monetary Fund, its Executive Board, or its Management. ⁎ Tel.: +202 623 7590; fax: +202 623 8291. E-mail address: stokarick@imf.org. 1 These b j terms are related to the terms a j used by CCS by b j ¼ 1 aj . 0165-1765/$ – see front matter © 2008 International Monetary Fund. Published by Elsevier Inc. All rights reserved. doi:10.1016/j.econlet.2008.04.008 Contents lists available at ScienceDirect Economics Letters journal homepage: www.elsevier.com/locate/econbase