Nontradable Goods in a Small Open Economy RBC

This chapter extends the small open economy RBC model by incorporating nontradable goods and introducing two distinct types of tradable goods. These enhancements enable an exploration of the dynamics of the real exchange rate, a metric that gauges the cost of the domestic consumption basket in relation to its foreign counterpart. Our approach closely aligns with the framework proposed by Mendoza (Int Econ Rev 36:101–137, 1995). Using this model, we delve into the ramifications of terms of trade shocks, which are widely recognized as pivotal drivers of macroeconomic fluctuations, especially within developing economies marked by sizable commodity export sectors.