The U.S. Dollar Real Exchange Rate a Real Option Approach

Abstract

The aim of this paper is to discuss the determinants of the U.S. dollar real exchange rate fluctuation. We focus our analysis on a nominal exchange rate effect on tradable prices. We explicitly consider the effects of profit maximizing foreign firms’ entry decisions on the domestic tradable prices through the supply changes after a large appreciation. If firms face sunk entry costs when breaking into foreign markets, the extent of pass-through will depend on the expected changes of nominal exchange rate. Typically, exchange rate uncertainty is determined as a volatility of continuos time series process. We enlarge the discussion to consider also possible jumps in the expected exchange rate time path. Finally, an interesting perspective is provided by a real option approach that emphasize dynamic supply effects through sunk costs and uncertainty.