Real Exchange Rate Movements and the Relative Price of Non-Traded Goods

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We study the quarterly bilateral real exchange rate and the relative price of non-traded to traded goods for 1225 country pairs over 1980–2005. We show that the two variables are positively correlated, but that movements in the relative price measure are smaller than those in the real exchange rate. The relation between the two variables is stronger when there is an intense trade relationship between two countries and when the variance of the real exchange rate between them is small. The relation does not change for rich/poor country bilateral pairs or for high inflation/low inflation country pairs. We identify an anomaly: The relation between the real exchange rate and relative price of non-traded goods for US/EU bilateral trade partners is unusually weak.