Country Size and the Transfer Effect
This paper studies how country size affects the role of the exchange rate in external adjustment. First, the impact of country size on the sensitivity of relative prices to external imbalances is explored in a standard two-country neoclassical model. Second, at the empirical level, a significant effect of external imbalances on relative prices is found. In particular, a trade surplus is associated with a deteriorating terms of trade and a declining relative price of non-traded goods, feeding into a depreciation of the real exchange rate. Estimation for G3 and non-G3 sub-samples reveals a systematic pattern in the sensitivity of relative prices to external imbalances, with the transfer effect stronger in larger countries.
Keywords: External imbalances; Relative prices; Transfer effect; Country size
JEL classification: F40; F41