Do sticky prices increase real exchange rate volatility at the sector level?

- We study the relationship between the infrequency of price changes and Law of One Price volatility.
- In theory, volatility is declining in the Calvo parameter in the presence of productivity shocks.
- In theory, volatility is rising in the Calvo parameter in the presence of money supply shocks.
- In general, the volatility curve is a U-shaped function of the Calvo parameter.
- Over the period of our study, productivity shocks account for the majority of the volatility.

We introduce the real exchange rate volatility curve as a useful device to understand the relationship between price stickiness and the fluctuations in Law of One Price deviations. In the presence of both nominal and real shocks, the theory predicts that the real exchange rate volatility curve is a U-shaped function of the degree of price stickiness. Using sector-level US-European real exchange rate data and frequency of price changes, we estimate the volatility curve and find the predominance of real effects over nominal effects. Good-by-good variance decompositions show that the relative contribution of nominal shocks is smaller at the sector level than what previous studies have found at the aggregate level, consistent with significant averaging out of good-specific real microeconomic shocks.