In this paper we show that nontraded goods (in ¯nal consumption and in retail services) play an important role in exchange rate behavior in the context of an otherwise standard open-economy macro model. In our model, nontraded goods have an important role even though °uctuations in the relative price of nontraded goods account for a small proportion of real exchange rate °uctuations. 3 Our quantitative study with nontraded goods generates implications along several dimensions that are more closely in line with the data relative to the model that abstracts from nontraded goods. In addition, contrary to a large literature, standard alternative assumptions about the currency in which ¯rms price.
