Price adjustment and exchange rate pass-through

Abstract

This paper develops a simple theoretical model that can be used to account for the determinants of exchange rate pass-through to consumer prices. While recent evidence has found low estimates of pass-through in many countries, there is little consensus on an explanation for this. Our paper argues that sticky prices represent a key determinant of exchange rate pass-through. We make this argument in two stages. First, holding the frequency of price change constant, we show that our model calibrated to data from low inflation countries can reproduce the estimates of very low pass-through for these countries. The principal determinant of low pass-through in this case is the slow adjustment of prices. We then extend the model to allow the frequency of price change to be endogenous. Calibrating to a wider set of countries, including both low-inflation and high-inflation countries, we show that our model implies that exchange rate passthrough is increasing in average inflation, but at a declining rate.

Exchange rate pass-through and inflation: A nonlinear time series analysis

“…Because the ERPT increases if more firms set an optimal price, and the probability of opting out depends on the past inflation rate, our model predicts that ERPT depends on the lagged inflation. This prediction is in contrast to the case of Devereux and Yetman (2010) where the ERPT depends on the steady-state inflation level of the economy. We show that the dynamics of ERPT predicted by the theoretical model can be well approximated by the STAR structure, and that the past decline during the 1980s and 1990s and the recent increase in the ERPT to US prices are well explained by the STAR model.…”

“…In particular, we employ the class of smooth transition autoregressive (STAR) models so that the degree of ERPT to domestic prices can be determined by the lagged domestic inflation rate. Most previous empirical studies on the positive association between ERPT and inflation focus on the cross-country evidence, including the analyses by Calvo and Reinhart (2002), Choudhri and Hakura (2006), and Devereux and Yetman (2010). This paper differs from the existing studies in that we examine the role of inflation in the time-varying ERPT under the time series modeling framework.…”

“…3 The basic setup is similar to Devereux and Yetman (2010) in that importing firms are monopolistic competitors who import differentiated intermediate goods from abroad. A representative domestic final good producer purchases all the imported intermediate goods and combines them to produce a final output.…”

“…Our model is closely related to a model of ERPT developed by Devereux and Yetman (2010) so that the optimal price level depends directly on the nominal exchange rate, which corresponds to the marginal cost, and that importing firms endogenously select the probability of adjusting their price to an optimal level. However, our model differs from their model in several aspects.…”

Virtual borders

“…Yet other types of rigidities may still be relevant, and our analysis indeed shows a significant degree of price stickiness for some retailers. 6 Choudhri et al (2005) and Devereux and Yetman (2010) also discuss the role of price stickiness in this context. Their analysis is however in terms of price aggregates, not micro price data.…”