NBER WORKING PAPER SERIESACCOUNTING FOR REAL EXCHANGE RATES USING MICRO-DATA
Mario J. Crucini
Anthony Landry
Working Paper 17812
http://www.nber.org/papers/w17812

NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
February 2012

This paper was written while Mario Crucini was a visiting senior fellow at the Globalization and Monetary
Policy Institute at the Federal Research Bank of Dallas. Mario Crucini gratefully acknowledges thefinancial support of the National Science Foundation. We are grateful to participants at the 2011 EconometricSociety Winter Meetings, the 2011 Canadian Macroeconomic Study Group Meetings, the 2011 Midwest
Macroeconomics Meetings, the 2010 Society for Economic Dynamics, the University of Melbourne,
Université Laval, the Federal Reserve Bank of Dallas, the Board of Governors of the Federal Reserve
System and Vanderbilt University. We particularly thank Dean Corbae, Mick Devereux, Rebecca Hellerstein,
Karen Lewis, John Rogers, and Robert Vigfusson for their detailed comments. The views in this paper
are our responsibility and should not be interpreted as reflecting the views of the Federal Reserve Bankof Dallas, the Federal Reserve System, or the National Bureau of Economic Research.
NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official
NBER publications.
© 2012 by Mario J. Crucini and Anthony Landry. All rights reserved. Short sections of text, not toexceed two paragraphs, may be quoted without explicit permission provided that full credit, including© notice, is given to the source.

Accounting for Real Exchange Rates Using Micro-data
Mario J. Crucini and Anthony Landry
NBER Working Paper No. 17812
February 2012
JEL No. F0,F2,F3,F4
ABSTRACTThe classical dichotomy predicts that all of the time series variance in the aggregate real exchange
rate is accounted for by non-traded goods in the CPI basket because traded goods obey the Law of
One Price. In stark contrast, Engel (1999) found that traded goods had comparable volatility to theaggregate real exchange rate. Our work reconciles these two views by successfully applying the classicaldichotomy at the level of intermediate inputs into the production of final goods using highly disaggregatedretail price data. Since the typical good found in the CPI basket is about equal parts traded and non-traded
inputs, we conclude that the classical dichotomy applied to intermediate inputs restores its conceptual
value.

Mario J. Crucini
Department of Economics
Vanderbilt University
Box 1819 Station B
Nashville, TN 37235-1819
and NBER
mario.j.crucini@vanderbilt.edu
Anthony Landry
Federal Reserve Bank of Dallas
2200 North Pearl Street
Dallas, TX 75204
and The Wharton School of the University of Pennsylvania
anthony.landry@dal.frb.org

1

Introduction

One of the most stable empirical relationships in international macroeconomics
is the comparable volatility of nominal and real exchange rates. This relationship was …rst documented by Mussa (1986) using a short panel of data following the breakdown of the Bretton Woods system of …xed nominal exchange
rates. Subsequent research has shown that this relationship is robust to longer
time spans of data and broader cross-sections of countries. Understandably,
these observations have been interpreted as evidence that goods markets arenationally segmented.
An enduring explanation for real exchange rate variability is the classicaldichotomy of Salter (1959) and Swan (1960). This is the notion that theconsumption basket consists of items which are imported, items which areexported and items which are produced only for domestic consumption. The
literature refers to items in the …rst two categories as traded goods and items in
the last category as non-traded goods. The use of the term goods is misleadingin the sense that some services are traded and some goods are not traded: toavoid confusion with conventional usage, the term goods will refer to all itemsin the consumption basket. According to the classical dichotomy, traded goods
satisfy the Law of One Price (LOP) up to a constant iceberg trade cost andthus the real exchange rate of traded goods is constant over time, leaving thereal exchange rate of non-traded goods to account for all of the time series
variation in the CPI-based real exchange rate.
In a highly in‡uential paper, Engel (1999) constructs traded and nontraded real exchange rates using sub-indices of the CPIs of the United Statesand its largest trading partners and conducts a variance decomposition ofbilateral aggregate real exchange rates into the contributions of the two subindices. In stark contrast to the predictions of the classical dichotomy, he…nds that real exchange rates of traded and non-traded goods contribute a
comparable amount to aggregate real exchange rate variability. His results
have shifted the consensus among economists from the classical dichotomy
view to the view that all …nal goods markets are equally segmented. And yet
the sources of market segmentation have been di¢ cult to pin down.
A voluminous literature on exchange rate pass-through shows that move1

ments in nominal exchange rates are not fully re‡ected in subsequent movements in destination prices (see Campa and Goldberg (2005) for a comprehensive treatment). Thus even the prices of highly traded goods are unlikely
to satisfy the LOP at the retail level since they fail to do so at the border.
The question then becomes not simply whether one can or should distinguishgoods and services in the stark manner suggested by the classical dichotomy,
but also whether it is productive to make more subtle distinctions in crafting
the architecture of modern international macroeconomic models.
The goal of this paper is to reassess the usefulness of distinguishing itemsin the consumption basket by the variation in their real exchange rates. Twocomplementary elements of novelty are introduced. The …rst is the use of
microeconomic retail price data in the variance decomposition of the aggregate
real exchange rate. The second is the application of the classical dichotomy tointermediate inputs into the production of individual …nal goods, rather thandichotomizing the …nal goods themselves.
To achieve the …rst step the aggregate real exchange rate for a typicalbilateral pair (i.e., suppressing bilateral location indices) is built from theground up using Law of One Price deviations, qit ,Xqt =! i qit ,(1)iwhere ! i is an item-level consumption expenditure weight. Due to the verylarge number of terms on the right-hand-side of this equation a conventionalvariance decomposition is not feasible. Instead, the covariance of each of the
LOP deviations is taken with respect to the aggregate bilateral real exchange
rate qt ; dividing all terms on each side of the equation by the variance of qt
gives the desired result:1=

cov(qt ; qt ) X cov(qit ; qt ) X=!i=!i i .
var(qt )
var(q
)
t
i
i

The use of the notation

i is deliberate.

(2)

It reminds the reader of the betas

used in portfolio analysis. In this application, the return on the portfolio is
replaced with the relative price of the same basket across two locations; theportfolio weights are the expenditure shares and the LOP deviations take therole of the returns on individual stocks in the portfolio. As a concrete example,2

values ofgreater than unity indicate items in the consumption basket that

contribute more than their expenditure share to the variability of the aggregate
real exchange rate.
Engel’s two-index decomposition is easily constructed by aggregating the
LOP deviations into sub-indices for traded goods and non-traded goods:
qt = (1where ! and 1!)qtT + !qtN ,(3)! are the aggregate consumption expenditure shares of goods

deemed to be either traded or non-traded. The variance decomposition becomes:
1 = (1These!) T + ! N .

(4)’s are simply expenditure-weighted averages of their microeconomic

counterparts
aggregates are:i.

The restrictions of the classical dichotomy applied to theseT= 0 andN= ! 1 . The …rst restriction is the notion that

the LOP is assumed to hold for all traded goods and thus also for the aggregate
traded real exchange rate index. The second restriction is an implication of
the …rst along with the de…nition of a variance decomposition. It is important
to note that in the aggregate version, the assumption about LOP only needs
to hold on average across traded goods. Given that roughly 0.6 of expenditureis attributed to non-traded goods based on the dichotomous classi…cation,N= 1:7 is predicted by the classical dichotomy when applied to …nal goods.
Using Economist Intelligence Unit (EIU) retail price data and U.S. expen-

diture weights for the ! i , the averageand the average for traded goods isTfor non-traded goods isN= 1:03= 0:81. In words: non-traded goods

contribute 22% more to the variability of the aggregate real exchange rate
than do traded goods. While this di¤erence is substantial and consistent in
direction with the classical dichotomy, the fact remains that the contributionof traded goods to the variance is much closer to that of non-traded goods than
it is to zero. It is on this basis that a consensus has emerged that most items
found in the consumption basket are exchanged in markets that are nationallysegmented. And at this level of aggregation, the EIU data broadly support
this conclusion and are therefore consistent with Engel’s …ndings using o¢ cial
CPI data.1
1

The aggregation used here corresponds closely to Engel’s results using CPI indices. He

3

There are two problems with this interpretation of the evidence. First, thelevel of aggregation of the CPI typically available to researchers is not designed
to achieve a partition of goods into traded and non-traded items. For example,
food includes both food away from home and groceries, housing includes both
rent and utilities –if forced to make a choice, the food away from home andrent would be placed on the non-traded side of the ledger while groceries andutilities would be placed on the traded side of the ledger. Since much of thedata is aggregated to the level of food and housing, the categories becomesless sharp at distinguishing traded and non-traded goods. However, the useof micro-price data in this study completely avoids categorization bias due toaggregation so either the problem is not acute or something else is making thetwo macroeconomic and microeconomic approaches appear more comparable.
This brings us to the second di¢ culty, the fact that …nal goods involve
both traded and non-traded inputs in their production. This violates the basic
premise of the classical dichotomy as applied to …nal goods except for carefully
chosen anecdotes. In the Economist Intelligence Unit (EIU) retail price surveyof 301 goods and services, there are only a handful of items purchased byconsumers with no obvious role for traded inputs (e.g., baby-sitting services
and monthly salary of a maid) and there are no items that could be reasonably
described as purely traded in the sense of the consumer paying shipping costs
and purchasing directly from the manufacturer or wholesaler (as would betrue of some online purchases, for example). The modal good in virtually all
national retail price surveys, including the EIU sample, is a food product soldin a grocery store, which, according to the U.S. NIPA data, has a non-traded
input share of 0.41.
Any hope of resuscitating the classical dichotomy therefore seems to require that the distinction between traded and non-traded goods be pushed
to the level of intermediate inputs used in the production of goods and services appearing in the consumption basket. The share of these non-traded
inputs in marginal cost have been dubbed distribution margins by Burstein,
Eichenbaum and Rebelo (2005) and are measured as the di¤erence between
classi…ed services and housing as non-traded and all other sub-indices of the CPI (referrred
to as commodities) as traded. We achieve basically the same classi…cation when we label
goods with a distribution cost share of 0.6 or higher as non-traded goods.

4the price paid by the …nal consumer and the price received by the manufacturer at the factory gate. Strictly speaking this measure applies only to goods
and not to services because the NIPA data treat the market for services as anarms-length transaction between the service provider and the end consumer.
That is, a medical bill paid by a consumer or health insurance company would
be recorded as having no distribution margin (or non-traded inputs) by thismeasure. This study uses the input-output tables of the United States tomeasure the traded and non-traded cost shares of services, following Crucini,
Telmer and Zacharadis (2005). It should also be noted that these measures
also include any markups over marginal cost at the wholesale and retail levels.
If the cost share of non-traded inputs took on two values, zero and unity,a researcher with measures of the shares could create a dichotomous variable
and formally test the validity of the theory using either microeconomic data or
aggregate indices. Such a test is infeasible because there are almost no itemsin the consumption basket at either of these two extremes. According to U.S.
NIPA data, the non-traded input share for food products is approximately
one-third, the median share in the EIU cross-section is 0.41 and the average is
0.50. The average is particularly telling since such goods should be viewed as
equally weighted in traded and non-traded inputs completely obscuring any
tendency for the classical dichotomy to hold at the level of intermediate inputs.
By way of example, and to illustrate our variance decomposition methodology, consider the dichotomy of the CPI employed by Engel: commodities
and shelter. An example of a commodity in the EIU micro-sample is a gallonof unleaded gasoline and an example of shelter is an unfurnished two-bedroom
apartment.

We have chosen these two items because they capture extreme

values of the non-traded cost share: 0.19 and 0.93, respectively. The betas forthese two items are 0.61 and 1.43, respectively. Notice the much greater degree of separation between these two betas than the averages reported above:
if non-traded good inputs are proxied by an apartment rental and traded goods
by a gallon of unleaded fuel, the di¤erence in the betas is now 82% –twice thevalue estimated using the traded and non-traded aggregates.
This represents real progress for the classical dichotomy, particularly when
one realizes that this di¤erence is likely to be an underestimate of the differences in the underlying input betas because even for this carefully chosen5anecdote the cost shares of non-traded inputs are not 0 and 1, but rather 0.19
and 0.93. Assuming traded inputs and non-traded inputs are di¤erent fromone another, but the same for a gallon of unleaded gasoline and an unfurnished two-bedroom apartment, they may estimated by solving two equations
in two unknowns. Using the betas for unleaded fuel and apartments, the values
for the traded and non-traded input betas that solve the two equations are:T

= 0:40 andN= 1:51. Note that the estimated non-traded beta is close

to the beta for apartments, 1.51 versus 1.43, due to the fact that 0.93 is close
to 1, whereas the estimated traded beta is much lower than that of unleaded
fuel, 0.40 versus 0.61, due to the fact that 0.19 is a considerable distance from
0. These indirect estimates of the underlying input betas for non-traded andtraded inputs di¤er by 111%.
To summarize, when we use two sub-indices of the CPI to construct a realexchange rate for traded and non-traded goods, non-traded goods contributeabout 27% more to aggregate real exchange rates than do traded goods. When
we use individual goods and services that most closely resemble traded andnon-traded items the gap widens to 82% and when we adjust the estimates toaccount for the distribution margins for each good, the gap widens further to111%. These calculations are representative of the broader cross-section andsuggest that the classical dichotomy is a very useful description of LOP deviations. Our interpretation of the invalidation of the classical dichotomy at thelevel of aggregate CPI indices is a combination of not distinguishing intermediate inputs from …nal goods and of using data too highly aggregated to preserve
interesting di¤erences in the traded factor content of …nal consumption goods.
Consistent with the pass-through literature on prices at the dock, signi…cant
LOP deviations remain even after controlling for non-traded inputs indicating
the existence of market segmentation where the classical dichotomy assumes
none exists: a purely traded input. The conclusion drawn from these variance decompositions is that a hybrid model with some market segmentationin traded goods and a good-speci…c distribution margin is a fruitful avenue for
future theoretical and empirical research.
The rest of the paper proceeds as follow. In Section 2, we present thedata. In Section 3, we describe our methodology and compute individual
contributions of LOP deviations to aggregate RER volatility. In Section 4,
6

we document a striking positive relationship between the magnitude of thecontribution of a LOP deviation to aggregate RER volatility and the costshare of inputs used to produce that good. Then, we develop and estimate
a two-factor model, and aggregate these factors to measure the contributionof intermediate inputs to aggregate RER volatility. In Section 5, we showthat our microeconomic decompositions, when aggregated, look very similar
to earlier studies using aggregate CPI data, but that the economic implications
are very di¤erent. Section 6 concludes.

2

The Data

The source of retail price data is the Economist Intelligence Unit Worldwide
Survey of Retail Prices. The EIU survey collects prices of 301 comparable
goods and services across 123 cities of the world. The number of prices overstates the number of items because many items are priced in two di¤erent
types of retail outlets. For example, all food items are priced in both supermarkets and mid-priced stores. Clothing items are priced in chain storesand mid-price/branded store. The prices are collected from the same physicaloutlet over time, thus the prices are not averages across outlets. The panel
used in this study is annual and spans the years 1990 to 2005. The local currency prices are converted to common currency using the prevailing nominal
exchange rates at the time the survey was conducted.
The data are supplemented with two additional sources from the U.S. Bureau of Economic Analysis: the National Income and Product Account andthe Industry Economic Accounts Input-Output tables. The …rst supplementary data series are consumption-expenditure weights. These data are moreaggregated than the EIU prices, leading us to allocate about 300 individual
retail prices to 73 unique expenditure categories. We divide the sectorial expenditure weights by the number of prices surveyed in each sector so that eachcategory of goods in the EIU panel has the same expenditure weight as in the
U.S. CPI index. As some sectors are not represented in the EIU retail pricesurveys, the expenditure weights are adjusted upward to sum to unity.
The second supplementary source are the distribution shares, the fractionof gross-output attributable to non-traded inputs. These include wholesale and7retail services, marketing and advertisement, local transportation services andmarkups. For goods, this is the di¤erence between what consumer pays andwhat manufacturer receives divided by that the consumer pays. For example,
if …nal consumption expenditure on bread is $100 and manufacturers receive$60, the distribution share is 0.40.
For services, however, what consumers pay and what sellers receive would
be the same value by this accounting method. In reality, when a consumer (orthat consumer’s health insurance provider) receives a medical bill, the charge
includes wage compensation for their doctor and the cost of any goods orother services included in the treatment, whether or not it is itemized on theinvoice. In these circumstances we use input-output data to measure nontraded and traded inputs. Each retail item in the EIU panel is reconciled with
one of these sectors and assigned that sector’s distribution share, leading to 30
unique sectorial shares. The median good as a distribution share of 0.41. The
economy-wide average distribution share weighted by …nal expenditure is 0.48
for US cities, 0.49 for OECD cities and 0.53 for non-OECD cities. Overall,our distribution shares are similar to those used in Burstein et al. (2003) andCampa and Goldberg (2010).

3

Microeconomic Decomposition

The theoretical construction of the aggregate real exchange rate appeals to autility function and the derivation of a corresponding price index.

Let Cjt

denote consumption by individual j at time t consisting of a Cobb-Douglas
aggregate of this individual’s consumption of various goods (and services),
Cijt , with weights ! i . We have:
U (Cjt ) =Y(Cijt )!i .

(5)iNote that the j index will also refer to the location where the individual
purchases the goods, which given the nature of our data will be a city. Notealso that the absence of an individual index on the ! i means that all individuals
have the same preferences.
Solving an expenditure minimization problem produces an ideal price index
in the sense that it maps the prices of individual goods and services into a8

single consumption de‡ator with the property that aggregate consumption isconsistent with the utility concept de…ned by the structure of preferences. For
the case of Cobb-Douglas preferences, the price index Pjt , is a simple geometricaverage of good-level prices Pijt with the consumption expenditure shares as
weights in the average:
Pjt =This de‡ator satis…es Pjt Cjt =PY(Pijt )!i .

(6)

i

i Pijt Cijt , where the quantities of aggregate

consumption and consumption of individual goods and services are the optimallevels chosen by consumers in city j, taking prices and income as given.
Converting prices to common currency at the spot nominal exchange rate,
leads to the de…nition of the aggregate real exchange rate (RER) Qjk;t forbilateral city pair j and k as a function of microeconomic relative prices:
Sjkt Pjt Y=
Qjk;t =Pkt
i

Sjkt Pijt
Pikt

!i

,

(7)

where Sjkt is the spot nominal exchange rate between city j and k. Taking logarithms leads to a relationship in which the RER is a consumption-expenditure
weighted average of Law of One Price (LOP) deviations2 :X
qjk;t =
! i qijkt .

(8)i

Our microeconomic variance decomposition is achieved by taking the covariance of the variables on each side of this expression with respect to qjk;tand dividing all terms on each side of the equation by the variance of qjk;t :1=

cov(qjkt ; qjkt ) X cov(qijkt ; qjkt ) X=!i=! i ijk ,var(qjkt )var(qjkt )
i
i

where
ijk =

cov(qijkt ; qjkt )std (qijkt )=var(qjkt )std (qjkt )corr (qijkt ; qjk;t ) .

(9)

(10)

The contribution of good i to the variance of the aggregate RER is given
by ! i ijk . It is increasing in that good’s weight in expenditure, the relative
standard deviation of its real exchange rate (relative to the aggregate) and its
2

Note this is also the de…nition for the aggregate real exchange rate for common CES
preferences, up to a …rst-order approximation.

9

correlation with the aggregate RER. Quite apart from economizing on degrees
of freedom in estimating a variance decomposition, the approach recognizes
that we are interested in the covariance of the LOP deviations with the aggregate RER.
To …x ideas, suppose all prices are …xed in local currency units during theperiod and then adjusted to satisfy the LOP at the end of the period, with anominal exchange rate change occurring during the period. Every single goodin the distribution would contribute exactly the same amount to the variance of
the aggregate RER,

ijk = 1. Suppose instead that all traded goods adjusted

instantaneously to the nominal exchange rate movement within the period
while non-traded goods took one period to adjust. Now non-traded goods
account for all of the variance and traded goods for none,TN= ! 1 and= 0, where ! is the share of expenditure on non-traded goods.
The …rst example characterizes the view that all goods markets are equallysegmented, that goods are all alike, at least for the issue of understanding
real exchange rates. The second example characterizes thrust of the classicaldichotomy, there are just two types of goods. The …rst view produces a degenerate distribution of the microeconomic ’s at 1, the second produces twodegenerate distributions, one for traded goods attraded goods at

NT= 0 and one for non-

= ! 1 = 1:7 (using a non-traded expenditure share of 0.6,

appropriate for our micro-data).
The obvious question to ask is: what does the distribution of

ijk look like?

Figure 1 presents three kernel density estimates: one pools all goods (blackline), one pools traded goods (red line) and one pools non-traded goods (blueline).

The vertical lines display their averages. This distribution has little

resemblance to either of the two views described above. There is far too muchvariation in the ’s to be consistent with the broad-brushed view that goods
markets are equally segmented internationally, the support of the distribution
extends from -2 to +4. At the same time, the distribution exhibits too muchcentral tendency toward its mean of 0.81 to be consistent with a dichotomousclassi…cation of …nal goods. If the classical dichotomy were to hold in the
micro-data, the pooled density should be bimodal with a proportion of thedata corresponding to traded goods centered at zero (no deviations) and theremaining proportion centered at 1.7. In fact, traded goods are centered at
100.76 and non-traded goods are centered at 1.03.
Table 1 reports summary statistics for the microeconomic variance decomposition. The mean beta for non-traded goods does exceed the mean for traded
goods in most cases, ranging from a di¤erence of 0.27 (1.03-0.76) for all cities
pooled together (Figure 1) to a low of 0.04 (0.87-0.83) for U.S.-Canada city
pairs. The relative standard deviation of the LOP deviations average twicethat of the aggregate real exchange rate, indicative of considerable idiosyncratic variation in LOP deviations. The mean correlation of LOP deviation
and PPP deviation is 0.45 in the pooled sample. As Crucini and Telmer (2011)
note, LOP deviations are not driven by a common factor such as the nominal
exchange rate, much of the variation is idiosyncratic to the good.
In summary the contribution of individual goods to aggregate real exchange
rate variability shows a central tendency, but with considerable variation acrossindividual goods. Certainly the distribution is not the stark bimodality expected from the classical dichotomy applied to …nal goods.

Our goal is tomaintain the two-factor parsimony of the classical dichotomy, but with the
tradability applied at the level of inputs. To accomplish this we …rst elaboratea simple two factor model that stands in for the two types of inputs. Importantly, the share of non-traded and traded inputs in the cost of the …nal good isassumed to vary across individual …nal goods as measured by the distribution
margin.

4

The Intermediate Inputs Model

Many researchers have argued that the classical dichotomy is more appropriate
to apply at the level of inputs than at the level of …nal goods. Up until quite
recently the data has not been available to conduct a systematic investigationof this hypothesis. We follow Engel and Rogers (1996) and Crucini, Telmer andZachariadis (2005), and assume that retail prices are Cobb-Douglas aggregatesof a non-traded input Wjt and a traded input inclusive of a transportation costfrom the source to the destination, Tijt :1
i
Pijt = Wjti Tijt
.

11

(11)

The LOP deviation (in logs) becomes,
qijkt =

i wjkt + (1i ) ijk;t ,(12)where each of the variables is now the logarithm of a relative price across abilateral pair of cities. Thus the LOP deviation for good i, across bilateralcity pair, j and k, depends on the deviation of non-traded and traded input
costs across that pair of cities, weighted by their respective cost shares.
Elaborating on the cost structure of individual goods and services in thisway adds an additional layer to the original variance decomposition. The
betas for the individual retail prices of …nal goods may now be expressed asa simple weighted average of the underlying betas for non-traded and traded
input prices:cov(qjkt ; qijkt )=var(qjkt )ijk

icov(qjkt ; wjkt )+ (1var(qjkt )=w
i jk + (1

=

ijk +

w
i ( jki)cov(qjkt ; ijk;t )var(qjkt )(14)i ) ijkijk ) .

This equation leads to two important insights. First, the

(13)

(15)
ijk for …nal goods

are predicted to be increasing in the share of non-traded inputs

i , provided

non-traded factor prices contribute more to RER volatility than do tradedfactor prices, ( wjkjk ) > 0. Note that this is a much weaker condition thanthe classical dichotomy where the relative prices of traded goods are assumed
not vary at all across locations ( jk = 0), in which case the model would reduce
to

ijk =

w
i jk .

Second, even if the classical dichotomy holds at the level oftraded inputs, it will not hold at the level of …nal goods since,

w
i jk

> 0.

Ironically, the anecdotes that are often drawn into the debate are precisely
the ones that elucidate the role of traded and non-traded inputs. Namely
goods at the extremes of the distribution in terms of high and low values of
i . Of course anecdotes are misleading unless they help us explain the broader

patterns in the data and aggregate RER variability, which is our focus.
Figure 2 presents a scatter-plot of the contribution of good i to the varianceof the bilateral RER averaged across international city pairs ( i ) against the
distribution share for that good (the non-traded input cost,
12

i ).

Two items

toward the extremes of the distribution share are explicitly labelled: 1 liter ofgasoline and a 2-bedroom apartment. Based on our reconciliation of the EIU
micro-data with the U.S. NIPA data on the distribution share, the distribution
share for gasoline is 0.19 while that of a 2-bedroom apartment is 0.93.
Three observations are immediate. First, there is a positive relationshipbetween a …nal good’s contribution to RER variability and its distribution
share, the correlation ofi and

i is 0.69. Second, goods at the extremes suchas fuel and shelter, which are often used to provide anecdotal evidence of tradedand non-traded goods, …t the classical dichotomy more closely than goods
toward the middle of the distribution, goods with an average distribution share.
Third, averaging across goods obscures the role of tradability of intermediate
inputs because the median good has a distribution share of 0.41, implying close
to equal shares of traded and non-traded inputs in the cost of production. Putdi¤erently–through the lens of the intermediate input model–examining themedian good is analogous to taking a simple average of fuel and shelter. Doingso averages away the di¤erences in the underlying cost structure of the twogoods. In the next section we develop a two-factor model to infer the role oftraded and non-traded inputs across the entire distribution of the micro-data.

4.1

Two-Factor Model

The objective of this section is to decompose the good-speci…c contributions
to aggregate RER variation into the role of traded and non-traded inputs usedin the production of each good. To accomplish this, we incorporate the factthat the cost of producing …nal goods involves di¤erent shares of non-traded
and traded inputs, thei parameters measured along the horizontal axis of

Figure 2. This answers the question: if the contribution of LOP variation infuel to the aggregate RER is 5%, how much of this contribution to variance iscoming from the traded inputs (gasoline) and how much is coming from thenon-traded inputs (the other costs associated with operating a gas station). To
achieve this, we estimate a two-factor model of theijk for each bilateral city

pair. These two factors, one for the non-traded input and one for the traded
input will later be aggregated back up to the level of the CPI to determine
how much of the variation in the aggregate RER is due to variation in RER

13

for non-traded and traded input costs.
To reduce the intermediate inputs model to a two-factor structure for eachbilateral city pair, the traded factor is assumed to be the sum of a component
common to all goods and an idiosyncratic component speci…c to the good:
ijk =

ijk .

jk +

(16)

The contribution of good i to the variation of the bilateral real exchange rate
across city pair j and k is now:
ijk =

where

ijk = (1the two factors and

4.2i ) ijk .

w
i jk + (1i ) jk + ijk ,In the language factor models, thei and (1(17)
w
jk andjk arei ), their respective factor-loadings.

Estimation

In the model of the previous section, the observables are the estimated betas, ijk ,and the distribution shares from the NIPA,
factors of interest,w
jk andi ; the unobservables are the two

jk . Consider the following linear regression model:
ijk = ajk + bjk

i + ijk .

(18)

Comparing this equation to the theoretical model, it is apparent that theconstant term and the slope parameter identify the two factors of interest:
jk

= ajk

(19)

w
jk

= ajk + bjk .

(20)

We perform this regression separately for each city pair using the

ijk esti-mated from the expenditure-weighted version of the aggregate RER to conformwith the existing macroeconomic literature. Note that since the distribution
shares are more aggregated than the betas, we take simple averages of the betas across i for goods that fall into each sector for which we have distribution
shares. Following this aggregation, equation (18) is estimated by Ordinary
Least Squares (OLS) to recover the non-traded and traded factors. We also
report results obtained by Weighted Least Squares where each observation is14

weighted by the inverse of the number of goods falling into each distributionshare sector (not shown), they are almost identical to the OLS estimates.
Table 2 reports the estimated factors averaged across city pairs within different country groups. The standard deviations across city pairs are reported
in brackets. The di¤erences across groups of locations and individual city
pairs is discussed in a subsequent section. The …rst column pools all city
pairs. The traded-factor averages 0.54 while non-traded factor averages 1.03.
This implies that, on average, non-traded inputs contribute twice as much as
traded inputs to RER variations. Recall that the average traded and nontraded goods have betas of 0.76 and 1.03. Notice that the traded input factor
is much lower than the average contribution of a traded good to aggregate realexchange rate variability while the non-traded factor is coincidentally equal
to the average contribution of a non-traded good to aggregate real exchange
rate variability. This re‡ects two interacting e¤ects. First, the non-traded factor is the dominant source of variation. Second, the average traded good has
far more non-traded factor input content than the average non-traded good.
Thus, most of the bias in attributing non-traded factor content in the decomposition is found in traded goods. To see this more clearly, it is productive to
examine the cross-sectional variance in the contribution of the non-traded andtraded factor at the microeconomic level rather than average across goods as
Table 2 does. We turn to this level of detail next.

4.3

The Role of Distribution Margins

Recall that after averaging the estimated equation (18) across jk pairs, wearrive at a decomposition of our original good-level betas:i= 1:03 i + 0:54(1= 0:54 + 0:50 i + i .

i) + i(21)(22)

Simply put, a purely traded good is one which involves no non-traded inputs,
i = 0.

If such a good existed in the retail basket, it would be predicted tocontribute 0.54 times its expenditure share to aggregate RER variability. At
the other end of the continuum, a purely non-traded good involves no traded
inputs,i = 1. If such a good existed, it would be expected to contribute 1.04

15

times its expenditure share to aggregate RER variability.
Table 3 shows the entire cross-sectional distribution of the good-speci…ccontributions to real exchange rate variation,i , decomposed in this manner.

Goods are ordered from those with the lowest distribution share (0.17), an example of which is a ‘compact car,’to goods with the highest distribution share(1.00), an example of which is the ‘hourly rate for domestic cleaning help.’
Note that each row is an average across goods sharing the same distribution
share (the second column) and the …rst column is just an example of a goodfound in that sector.
Since the non-traded input beta,w
jk , average 1.03, the contribution of the

non-traded input is approximately equal to the distribution share,i . By our

metric a compact automobile looks a lot like 1 liter of unleaded gasoline, butvery distinct from a two-bedroom apartment or the hourly rate for domestic
cleaning help. The contribution of LOP variation in each of the former twocases are about 70% traded inputs and 30% non-traded inputs whereas thelatter two are largely driven by the non-traded input factor. Another interesting comparison is fresh …sh and a two-course meal at a restaurant. Bothare treated as traded goods when CPI data are used because they fall into thesame category, food. However, one is food at home (fresh …sh) and the otheris food away from home (two course meal at a restaurant). Should they betreated similarly, as food items, or di¤erently as food at home and food awayfrom home? Consistent with the two factor intermediate input model, Table
3 provides a de…nitive answer: treat them di¤erently. Fresh …sh is indistinguishable from unleaded gasoline both in terms of the dominate role of traded
inputs and the relatively moderate contribution to aggregate real exchange
rate variation (0.65). A restaurant meal is dominated by the non-traded factor (85 percent) and contributes 35% more to aggregate real exchange ratevariability than does fresh …sh.
A good with a median distribution share (0.41) is toothpaste. Despite thefact that the cost of producing this good is skewed moderately toward traded
inputs (59% traded inputs), non-traded inputs still dominate in accounting forthe toothpaste beta, 0.40 versus 0.31 for traded inputs. This re‡ects the factthat our estimated non-traded factor is twice as important as our estimatedtraded factor in accounting for variation in the aggregate RER, 1.04 versus
160.54. Stated di¤erently, for the traded input factor to dominate in contribution
to variance requires a distribution share of less than 0.34 (i.e. a traded input
share of more than 0.66).

4.4

The Role of Location

When focusing on the role of the distribution margin, it was productive toaverage across bilateral pairs. Similarly, when focusing on the role of location,
it is useful to average across goods. Recall, however, that the two estimatedfactors are location-speci…c and the group means of Table 2 suggested the presence of variation across location pairs in the two factors. To better visualize
the full extent of the variation without presuming a source of the variation
across city-pairs, Figure 3 presents kernel density estimates of the non-traded
and traded factors.
The …gure e¤ectively convey three messages. The …rst, and central message, is that there is a strong central tendency toward the means initiallyreported in Table 2 (for both of the factors), supportive of the parsimony imposed by the two factor model. The second message is that the contributionsof traded and non-traded inputs to aggregate RER variability are much moreeasily distinguished than was true of traded and non-traded goods. This isevident in comparing the two distributions in Figure 3 with their counterpartsin Figure 1. Third, the dispersion across locations in the estimated factors is
signi…cant and greater for the estimated traded factor (red line) than the estimated non-traded factor (blue line), consistent with the impression conveyed
by the group-mean coe¢ cients –reported in Table 2.3
What is responsible for the variation across location pairs in these distributions? Figure 4 plots the non-traded and traded input betas for each bilateralcity pair against the standard deviation of the nominal exchange rate for thatbilateral city pair.

Two features are notable. First, there is a positive andpossibly concave relationship between the variability of the nominal exchange
rate and both the non-traded and traded input betas in the variance decom3

With regard to the classical dichotomy, we could not reject the hypothesis that thetraded-inputs beta is 0 for 56% of the sample. This statistics was computed using a twotailed t-distribution with 95% con…dence intervals.

17

position. Second, the estimated non-traded input betas lie above the traded
input betas.
The positive correlation between the estimated input betas and the volatility of the nominal exchange rate is more subtle. It is important to emphasizethat this correlation is not simply a re‡ection of the positive covariance of
nominal and real exchange rates documented in the existing macroeconomics
literature. Recall, the betas are components of a variance decomposition andthus have already been normalized by the level of the variance of the bilateralreal exchange rate. What is happening as the nominal exchange rate variance increases is that the common source of LOP variation is rising relative tothe idiosyncratic sources of variation. This occurs because movements in thenominal exchange rate are almost by de…nition a common source of variability
in LOP deviations.4 Since the non-traded factor is expected to exhibit lesspass-through of nominal exchange rates to local currency prices, at least in
the short run, it is also expected that the non-traded factor will lie uniformly
above the traded factor. This is evident, the blue dots lie mostly above the red
dots at each point along the x-axis (i.e. conditional on a value for the nominal
exchange rate variance). This is not to say that changes in nominal exchange
rates are causing real exchange rates to vary, to identify the underlying causesof variation would require a richer model. For example, a monetary shock islikely to alter both the distribution of local currency prices and the nominal
exchange rate whereas a crop failure in a particular country is unlikely to doeither of these things. The thrust of the …gure, however, is that real andnominal sources of business cycle variation are likely to play di¤erent roles indetermining the traded and non-traded input betas we have estimated.
To summarize, we have demonstrated that the classical dichotomy is a very
useful theory of the LOP when the theory is applied to inputs. What we do in
the next section is show that this is also true at the aggregate level. Moreover,4

Crucini and Telmer (2011) decompose the variance of the LOP deviations into timeseries variation and long-run price dispersion using the same data employed here. They…nd, as Engel did, that the time series variability of real exchange rates of traded goods iscomparable to that of non-traded goods whereas the long-run price dispersion goes in the
direction of the classical dichotomy with more international price dispersion among nontraded goods. Thus, our paper seeks to resolve the more puzzling feature of the data, its
time series properties.

18

we also show that the EIU data are entirely consistent with the conclusions of
the existing literature using aggregative CPI data when the theory is applied
to …nal goods. Our interpretation, however, is very di¤erent.

5

Macroeconomic Decompositions

Macroeconomics is, of course, about aggregate variables. Our thesis is that if
given the choice, macroeconomists would want to aggregate …nal goods basedon their non-traded and traded factor content. Our methodology attempts toprovide that choice. Here, we demonstrate the importance of this choice.

5.1

Aggregation Based on Intermediate Inputs

Recall that the microeconomic variance decomposition of the aggregate realexchange rate based on …nal goods is:
1 =

X

(23)

! i ijkiijk=

std (qijkt )cov(qijkt ; qjkt )=var(qjkt )std (qjkt )corr (qijkt ; qjk;t ) .

Substituting our two-factor model for the LOP deviation,(24)w
i jk + (1ijk =i ) jk + ijk , into this equation gives the theoretically appropriate method of

aggregating the micro-data based on the model of intermediate inputs:
1=

X

!i

w
i jk + (1i ) jk + ijk

.

(25)

i

Notice that since the two intermediate factors are assumed to be locationspeci…c, not good speci…c, the expression aggregates very simply to a twofactor macroeconomic decomposition:
1=w
jk + (1

)

jk +

jk ,

where the weights on the traded and non-traded input factors,(26)
and (1)are consumption expenditure-weighted averages of the shares of non-traded
and traded inputs into each individual good in the consumption basket. The
residual term,

jk is an expenditure-share weighted average of the

19

ijk .

In other words: the variance of the aggregate real exchange rate may be
expressed as a weighted average of the two factors estimated from the microdata. The weight on each factor depends on the relationship between taste
parameters and relative prices that determine consumption expenditure sharesand production parameters, and relative factor prices that determine distribution shares. Recall that the median distribution share in the micro-data is
0.41. The weight on the non-traded factor, , turns out to be much greaterthan this average because consumption tends to be skewed toward services
which are intensive in distribution inputs. Using US NIPA data and the EIU
micro-sample,= 0:69. The dominant weight on the non-traded input fac-

tor, combined with the fact thatw
jk is about twice the magnitude of

jk is

the reason that non-traded inputs dominate the variance decomposition of theaggregate real exchange rate by a very large margin.
Table 4 shows just how large. The table reports the results using OLS estimates (WLS results are very similar). Beginning with the averages across theentire world sample, the non-traded factor accounts for about 81% (i.e.: 0.71/(0.71+0.17)) of the variance of the aggregate real exchange rate, while traded
inputs account for the remaining 19%. The contribution of non-traded andtraded inputs is moderately more balanced in the U.S.-Canada sub-sample,
with non-traded inputs accounting for 73% and traded inputs accounting forthe remaining 27%. Consistent with our earlier microeconomic decompositions, the OECD looks more like the U.S.-Canada sub-sample than does the
non-OECD group.

5.2

Aggregation Based on Final Goods

An alternative two-factor macroeconomic model of the real exchange rate is
to apply the classical dichotomy at the level of …nal goods. To implement
this using the micro-data we must …rst decide on a de…nition of a non-traded
good. In theory, the micro-data provides an advantage because it allows us,
for example, to assign …sh to the traded category and restaurant meals to
the non-traded category, rather than placing all food in the traded category.
The rule we use to be consistent with the intermediate input concept of theclassical dichotomy is to categorize a good as a ‘non-traded good’if it has a20

distribution share exceeding 60 percent. This cuto¤ corresponds to a jumpin the value of the distribution shares across sectors from 0.59 to 0.75 (seeTable 3 or Figure 2). Coincidentally, this categorization matches up very wellwith the categorical assignments used by Engel (1999) who used much moreaggregated data. The traded-goods category includes: cars, gasoline, magazine
and newspapers, and foods. The non-traded goods category includes: rents andutilities, household services (such as dry cleaning and housekeeping), haircuts
and restaurant and hotel services.
With the assignments of individual goods and services to these two categories, the aggregate real exchange rate is:N
qjk;t = !qjkt+ (1T!)qjkt.

(27)

NT
where qjkt
and qjktare the bilateral real exchange rates for non-traded …nal

goods and traded …nal goods built from the LOP deviations in the microeconomic data, weighted by their individual expenditure shares.5
The variance decomposition of the aggregate real exchange rate is conducted using our beta method6 :1=! N
jk + (1!) Tjk .

(28)

Table 5 reports the outcome of the variance decomposition arising from thismacroeconomic approach. It is instructive to compare Table 5 to Table 1 since
they both use …nal goods as the working de…nition for traded and non-traded
goods. What is the consequence of aggregating the data before conducting thevariance decomposition? As it turns out, the betas are very similar across thetwo approaches. The average beta for non-traded (traded) goods pooling all
location is 1.17 (0.78) using the two index construct (Table 5) compared to
1.03 (0.76) using the microeconomic decomposition. These are relatively small
More precisely, the weights used earlier are renormalized to !!i ( 1!i! ) for non-traded(traded) goods so that the weights on the two sub-indices sum to unity.
6
The relationship between the microeconomic betas of our original decomposition andX
this two-factor decomposition is straightforward: ! jk N
! ijk ijk , and (1 ! jk ) Tjk =
jk =
5

X

i2N

! ijk ijk .

i2T

21

di¤erences. The underlying sources of the contribution to variance, however,are di¤erent.
When using the macroeconomic approach, the non-traded real exchange
rate contributes more to the variability of the aggregate RER for two reasons.
First, the non-traded real exchange rate is more highly correlated with theaggregate real exchange rate than is the traded real exchange rate (0.96 versus0.86). Reinforcing this e¤ect is the fact that the non-traded sub-index of the
CPI is more variable than the traded real exchange rate (1.22 versus 0.91). In
contrast, when the microeconomic approach is used, non-traded and traded
goods are not distinguished by the relative volatility of their LOP deviation (atleast for the median good). Both types of goods have standard deviations twicethat of the aggregate real exchange rate. Consistent with the macroeconomic
approach, the LOP deviations of the median non-traded good has a higher
correlation with the aggregate real exchange rate than does the median traded
goods (0.55 versus 0.42). Thus traded goods have more idioynscratic sourcesof deviations from the LOP than do non-traded goods.

5.3

The Role of Location

Location also plays a role in determining the relative importance of tradedand non-traded goods in accounting for real exchange rate variability. Figure
5 presents the entire distribution of thejk for the case in which all locations

are averaged (the …rst column of Table 5). The means for all goods, nontraded goods and traded goods from Table 5 are indicated with vertical lines at
0.97, 1.17 and 0.78, respectively. We see considerable variation in the relative
importance of non-traded and traded sub-indices of the CPI across bilateralcity-pairs, but the two distributions clearly have a di¤erent …rst moment, which
was not at all obvious in the microeconomic distributions of Figure 1.

5.4

The Compositional Bias

To further clarify the di¤erence between the implications of the classical dichotomy applied to intermediate inputs and …nal goods, this section estimatesthe compositional bias arising from using …nal goods to infer the factor content
of trade at the level of the two sub-index deconstruction of the aggregate real22

exchange rate. Consider the traded and non-traded partition based on …nal
goods and how the variance decompositions relate across the two methods.
The contribution of the non-traded aggregate real exchange rate to aggregate RER variability is:
! N
jk =

X

w
i jk + (1!ii ) jk

,

(29)

i2N

while the contribution of the traded aggregate real exchange rate to the aggregate RER variability is:(1!) Tjk =Xw
i jk + (1!i.

i ) jk(30)

i2T

Note that each contribution is written on the right-hand-side in terms of theintermediate input model.
Recall, the contribution of non-traded inputs to the variation in the aggregate RER variance according to the intermediate inputs model is actually:
!
X
w
w
!i i
(31)
jk =
jk ,
i

while the counterpart for the contribution of traded inputs is:!
X(1) jk =! i (1
i)
jk .

(32)

aggregate RER variance arising from using the …nal goods de…nition is
!
X
X
w
w
! N
!i i
!i i wi ) jkjkjk =jkjk + (1(33)

iUsing these four equations, the bias in the estimate of non-traded inputs to

i

=

X

!i i

i2T

!

i2N

w
jk

(1

)

jk

(1 ! jk ) Tjk =! ijk (1

i2N

i)

!

!

! i (1

i)

jk

X

i2N

and likewise, the bias for traded goods is
X

X

i2T

jk .

! ijk i

(34)
!

w
jk .

(35)

Table 6 reports the average share of non-traded goods together with the tradedand non-traded basket average contributions to RER volatility when all city
pairs are used in the comparison. The aggregate contribution of traded goods
using aggregation to …nal goods is about twice the their true underlying contribution based on the intermediate inputs model, 0.34 versus 0.17.
23

5.5

Relation with the Existing Literature

Engel (1999) and other researchers focus on whether RER ‡uctuations areprimarily associated with movement in the relative price of tradable goods
across countries or with movements in the relative price of non-tradable totradable goods. The equation Engel works with is
qt = qtT + (1!)(qtN

qtT ) ,

(36)

while we work with
qt = !qtT + (1!)qtN .

(37)

Simple algebra allows us to express Engel’s variance decomposition in termsof betas for traded and non-traded baskets:
1=

T

+ (1

!)( N

T

).

(38)

Engel’s variance decomposition split the RER volatility into two components.
The …rst component is the volatility in the traded basket RER. The second
component is the variance between non-traded and traded basket prices. The
approximate equality in the average betas for non-traded and traded baskets
explains why this decomposition attributes almost all of the variance in RER
to traded goods: Since the baskets’NTture weights, 0.13 using equal weights) and 1

is about 0.39 (using expendi! is less than one,

T

must

be close to 1 as Engel’s reports. This implies that the remaining volatility
must be explained by the traded basket RER. SinceT

is 0.78, 78 percent of

RER ‡uctuations are attributable to movements in the relative price of traded
goods.7
As we saw in the previous sub-section, an important bias arise when one
use traded and non-traded baskets’contributions. Using our two factor model,
Engel’s decomposition becomes:
1=
Since

+ ( w

) + "jk .

(39)

is 0.54, this implies that 54 percent of RER ‡uctuations are attribut-

able to movements in the relative price of traded intermediates.8 From this7

Using US-CA pairs, 88 percent of RER ‡uctuations are attributable to movements in
the relative price of traded goods compared to 95 percent as reported in Engel’s work.
8
For US-CA pairs, this number rises to 67 percent.

24

point of view, a considerable amount of volatility is coming from the relative
price of non-tradable to tradable intermediates.
A number of researchers modify Engel’s decomposition, but largely reinforce his conclusions about traded good prices. Out of concern about thefunctional form of the Cobb-Douglas aggregates, Betts and Kehoe (2006) workwith:
qt = qtT + (qtqtT ) ,

(40)

where qtT is a producer price index which is not contaminated by non-traded
distribution services. This decomposition preserves the identity on the left
and right-hand-side of the equality as necessary for a variance decompositionand has the desired attributes of using the producer price index, which isarguably a better proxy for traded goods prices than is an aggregate of consumer prices across highly traded goods. As is also apparent, there is no needto assign expenditure weights in the decomposition. Again, using our variancedecomposition the beta-representation of the decomposition is:
1=

+ (1

) + "jk .

(41)

The variance to be explained is the same as in Engel’s original contribution,
namely the variance of the aggregate CPI-based real exchange rate. However,the variance of the traded goods prices is di¤erent, since producer prices replace
the traded-CPI component on the right-hand-side. As one might expect, thevariance of producer prices is higher than consumer prices, but the covarianceof producer prices with the aggregate CPI may be lower. Since the beta is risingin relative variability and covariance, the implication of replacing a consumer
price index for traded goods with a producer price index is expected to be
ambiguous. These nuances notwithstanding, Betts and Kehoe …nd a modest
reduction in the contribution of traded goods relative to Engel.
Parsley and Popper (2009) take a microeconomic approach using two independent retail surveys in the United States and Japan. the U.S. survey isconducted by the American Chamber of Commerce Researchers Association(ACCRA) and the Japanese survey is from the Japanese national statisticalagency publication: Annual Report on the Retail Price Survey. Both containaverage prices across outlets, at the city level. The Japanese survey is vastly
25

more extensive in coverage of items than the ACCRA survey since it represents the core micro-data that goes into the Japanese CPI construction. Bothdata panels are at the city level and thus is quite comparable in many ways to
the EIU data. Parsley and Popper restrict their sample to items that are ascomparable as possible across the two countries. This selection criteria leaves
them with a sample of highly traded goods.
To elaborate our method when micro-data are employed, rather than two
sub-indices, consider applying item-speci…c weights, ! i to LOP deviations.
The aggregate real exchange rate becomes:
qt =X! i qi;t ,

(42)

i

Parsley and Popper follow Engel’s approach by placing an individual good in
the lead position with a unit coe¢ cient as its weight. That is, for each goodi, they work with:
qt = qi;t +MX! g qg;t

qi;t

g

!

.

(43)

Parsley and Popper then compute the variance of the lead term, the LOP
variance and divide it by the total variance of the real exchange rate andde…ne this ratio as the contribution of good i to the variance of the aggregate
real exchange rate.
In terms of betas, their variance decomposition is:1=

i + (1

i)

.

(44)

This is because the expenditure weighted average of the betas must equal unity
by construction. However, the variance decomposition following our method
is:
1 = !i i +X!g g ,(45)

g6=i

As is evident, the good-speci…c variance contributions of Parsley and Popper’s are actually equal to our betas. However in following Engel’s approachthey give each good a unit weight. As our decomposition shows, these goodspeci…c betas need to be multiplied by expenditure shares in order to conduct
a legitimate variance decomposition.
26

Parsley and Popper end up reconciling 28 items across the U.S. and Japan,
2 of which are services. They compute the contribution to variance at di¤erent
horizons, including 5 quarters. At this horizon the good-speci…c contributions
range from just under 0.5 to about 0.86. Interpreted as betas, these estimatescertainly fall within the range we …nd, which spans negative values to values
exceeding 1. However, they are not contributions to aggregate real exchange
rate variance, to arrive at a legitimate variance decomposition each beta mustbe multiplied by its consumption expenditure weight.

6

Conclusions

Using retail price data at the level of individual goods and services across many
countries of the world we have shown the classical dichotomy is a useful theory of international price determination when applied to intermediate inputs.
Speci…cally, by parsing the role of non-traded and traded inputs at the retaillevel a signi…cant source of compositional bias is removed from the micro-data
and di¤erences in the role of the two inputs is evident. Aggregate price indices
are not useful in uncovering this source of heterogeneity in LOP deviations
for two reasons. First, the dividing line between traded and non-traded goods
at the …nal goods stage is arbitrary and more under the control of o¢ cials at
statistical agencies whose goal is not to contrast the role of trade across CPI
categories of expenditure. Second, even at the lowest level of aggregate possible, most goods and services embody costs of both local inputs and traded
inputs. Consequently, the contribution of each LOP deviation to PPP deviations is a linear combination of the two components with the weights on thetwo components di¤ering substantially in the cross-section.
Our results point to the usefulness of microeconomic theories that distinguish traded and local inputs and their composition in …nal goods as well as animportant role of LOP deviations at the level of trade. This points to the needfor a hybrid model with a distribution sector and segmentation at the levelof traded inputs. In arguing for one stripped down model or another, macroeconomists may unwittingly reject virtually all useful theories of international
price determination.

27

References[1] Betts, Caroline and Timothy Kehoe. 2006. US Real Exchange Rate
Fluctuations and Relative Price Fluctuations. Journal of Monetary Economics, 53(7): 1257-1326.
[2] Burstein, Ariel, Joao Neves and Sergio Rebelo. 2003. Distribution
Costs and Real Exchange Rate Dynamics during Exchange-Rate Based
Stabilizations. Journal of Monetary Economics, 50(6): 1189-1214.
[3] Burstein, Ariel, Martin Eichenbaum and Sergio Rebelo. 2005.
Large Devaluation and the Real Exchange Rate. Journal of Political
Economy, 113(4): 742-784.
[4] Campa, José Manuel and Linda S. Goldberg. 2005. Exchange Rate
Pass-through into Import Prices. The Review of Economics and Statistics,
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[5] Campa, José Manuel and Linda S. Goldberg. 2010. The Sensitivityof the CPI to Exchange Rates: Distribution Margins, Imported Inputs,
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[6] Crucini, Mario J., Chris I. Telmer and Mario Zachariadis. 2005.
Understanding European Real Exchange Rates. American Economic Review, 95(3): 724-738.
[7] Crucini, Mario J., Chris I. Telmer. 2011. Microeconomic Sources ofReal Exchange Rate Variability. Manuscript.
[8] Engel, Charles and John Rogers. 1996. How Wide is the Border?
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28

[11] Popper, Helen and David C. Parsley. 2006. Understanding RealExchange Rate Movements with Trade in Intermediate Products. Paci…cEconomic Review, 15(2): 171-188.
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29

Table 1: Variance decomposition of real exchange rates,
microeconomic approach
All pairsOECD

Non-OECD

US-Canada

Std. dev. RER

0.14

0.13

0.13

0.10

Number of city pairs

4835

1543

856

52

Non-traded weight

0.57

0.56

0.58

0.55

Traded weight

0.43

0.44

0.42

0.45

Beta

0.81

0.84

0.74

0.83

Correlation

0.45

0.43

0.42

0.38

Rel. std. dev. LOP

2.00

2.18

1.98

2.19

Beta

1.03

0.95

1.11

0.87

Correlation

0.55

0.50

0.57

0.46

Rel. std. dev. LOP

2.00

2.10

2.07

1.89

Beta

0.76

0.81

0.63

0.83

Correlation

0.42

0.42

0.37

0.36

Rel. std. dev. LOP

2.00

2.20

1.95

2.26

All goods

Non-traded goods

Traded goods

30Table 2: Traded and non-traded inputs regressions,international pairs
All pairsOECD

Non-OECD

US-Canada

0.54

0.65

0.34

0.67

(.49)

(.46)

(.52)

(.52)

1.03

0.96

1.12

0.82

(.34)

(.32)

(.37)

(.26)

0.50

0.30

0.78

0.15

(.72)

(.64)

(.79)

(.64)

R-squared

0.08

0.05

0.12

0.04

Number of pairs

4835

1543

856

52

beta (traded)beta (non-traded)

slope

Note: Minimum of 4 observations per city pair.

31

Table 3: Variance decomposition using intermediate inputs betas
Contribution
ExampleNon-tradediNon-Traded

TradedResidualCont. (%)

Compact car (1300-1799 cc)

0.17

0.17

0.44

0.07

28%

Unleaded gasoline (1 liter)

0.19

0.19

0.43

-0.02

30%

Fresh …sh (1 kg)

0.22

0.21

0.44

0.07

32%

Time (news magazine)

0.32

0.32

0.36

0.05

47%

Toilet tissue (two rolls)

0.34

0.34

0.34

0.00

50%

Butter (500 g)

0.36

0.36

0.33

-0.01

52%

Aspirin (100 tablets)

0.37

0.36

0.34

0.01

51%

Marlboro cigarettes (pack of 20)

0.37

0.37

0.33

0.06

53%

Electric toaster

0.39

0.38

0.33

0.02

54%

Toothpaste with ‡uoride (120 g)

0.41

0.40

0.31

-0.05

57%

Compact disc album

0.41

0.41

0.30

-0.05

57%

Insect-killer spray (330g)

0.45

0.45

0.27

-0.03

62%

Paperback novel

0.49

0.47

0.27

-0.03

63%

Razor blades (5 pieces)

0.49

0.49

0.27

-0.01

64%

Batteries (two, size D/LR20)

0.50

0.49

0.27

-0.04

65%

Socks, wool mixture

0.52

0.52

0.25

0.05

68%

Men’s shoes, business wear

0.52

0.52

0.25

0.03

67%

Lettuce (one)

0.52

0.52

0.25

0.05

68%

Frying pan (Te‡on)

0.53

0.53

0.25

-0.01

68%

Light bulbs (two, 60 watts)

0.57

0.57

0.22

-0.18

72%

Child shoes, sportwear

0.59

0.58

0.21

-0.03

73%

Tennis balls (Dunlop, Wilson or equivalent)

0.59

0.59

0.21

-0.11

74%

Two-course meal at a restaurant (average)

0.75

0.75

0.13

0.00

85%

Electricity, monthly bill (average)

0.76

0.75

0.13

0.04

86%

Man’s haircut (tips included)

0.85

0.85

0.08

-0.04

91%

Taxi, airport to city center (average)

0.86

0.85

0.07

-0.01

92%

Telephone line, monthly bill (average)

0.92

0.90

0.04

0.03

96%

2-bedroom apartment

0.93

0.91

0.04

0.24

96%

Annual premium for car insurance

0.94

0.93

0.03

0.01

97%

Hourly rate for domestic cleaning help

1.00

1.00

0.00

-0.08

100%

32

Table 4: Macroeconomic variance decomposition,intermediate input approach

Non-traded share ( )All pairsOECD

Non OECD

US-CA

0.69

0.69

0.69

0.68

(.02)

(.20)

(.02)

(.02)

0.17

0.20

0.10

0.21

(.15)

(.14)

(.16)

(.17)

0.71

0.66

0.78

0.56

(.23)

(.22)

(.25)

(.18)

0.12

0.14

0.12

0.23

(.20)

(.22)

(.21)

(.21)

4835

1543

856

52

Contribution ofTraded inputs

Non-traded inputs

Error term

Number of city pairs

33

Table 5: Variance decomposition of real exchange rates,
macroeconomic approach
All

OECD

Non-OECD

US-Canada

Std. dev. RER

0.14

0.13

0.13

0.10

Number of city pairs

4835

1543

856

52

Non-traded weight

0.57

0.56

0.58

0.55

Traded weight

0.43

0.44

0.42

0.45

Beta

0.97

0.98

0.96

0.99

Correlation

0.91

0.92

0.89

0.94

Rel. std. dev. LOP

1.06

1.06

1.08

1.05

Beta

1.17

1.14

1.23

1.10

Correlation

0.96

0.96

0.96

0.96

Rel. std. dev. LOP

1.22

1.18

1.29

1.15

Beta

0.78

0.82

0.69

0.88

Correlation

0.86

0.88

0.82

0.92

Rel. std. dev. LOP

0.91

0.94

0.86

0.96

All goods

Non-traded goods

Traded goods

34

Table 6: Compositional bias
Aggregate using

Aggregation using…nal goods

Intermediate inputs

0.57

0.69

Traded0.34 (34%)

0.17 (19%)

Non-Traded

0.66 (66%)

0.71 (81%)

Non-traded share
Contribution

35

Figure 1: Density Distributions of Betas, Microeconomic Decomposition
0.035

All goods
Traded goods
Non-traded goods

0.03

Density

0.025

0.02

0.015

0.01

0.005

0

-2

-1

0

1

Beta

36

2

3

4

Figure 2: Sectoral Betas and Distribution Shares
1.6

Averaged Beta

1.4

1.2

1

0.8

0.6

0.4
0

0.1

0.2

0.3

0.4

0.5

0.6

Distribution Share

37

0.7

0.8

0.9

1

Figure 3: Density Distributions of Factor Betas
0.045
0.04

Traded inputs
Non-traded inputs

0.035

Density

0.03
0.025
0.02
0.015
0.01
0.005
0
-1

-0.5

0

0.5

1

Factor Beta

38

1.5

2

2.5

Figure 4: Factor Betas and Nominal Exchange Rate Volatility
43Traded goods
Non-traded goods

Factor Beta

2
1
0
-1
-2
-3
-2

-1.5

-1

-0.5

0

0.5

1

1.5

Nominal exchange rate growth std. dev . (log 10)

39

2

2.5

3

Figure 5: Density Distributions of Betas, Macroeconomic Decomposition
0.035

0.03

All goods
Traded goods
Non-traded goods

Density

0.025

0.02

0.015

0.01

0.005

0
-0.2

0

0.2

0.4

0.6

0.8

Beta

40

1

1.2

1.4

1.6

1.8