LAUSR

This paper introduces intermediate goods trade into a two-country real business cycle model and examines its implications for real exchange rate behavior. Intermediate goods trade is shown to reduce “exchange rate disconnect” by increasing the volatility of the real exchange rate relative to output and weakening the link between the real exchange rate and output. Intermediate goods trade also reduces the volatility of the terms of trade relative to the real exchange rate while increasing international output correlations and reducing the correlation between the trade balance and output.