Pricing to Market, Staggered Contracts, and Real Exchange Rate Persistence

Abstract

A prominent question in international macroeconomics is why real exchange rates exhibit persistent deviations from purchasing power parity. Table 1 reiterates the basic findings of the preceding literature, using quarterly data for 1973-1997. 1 Averaging over countries, the onequarter autocorrelation is about 0.8, and that over four quarters is 0.27. 2 A related time-series literature concludes that the real exchange rate may be even more persistent. 3 In addition, the table shows the real exchange rate is quite volatile, with a standard deviation between four to five times that of output on average.Sticky prices are one explanation commonly offered for these real exchange rate movements. Monetary shocks could induce an immediate change in the nominal exchange rate, and this would translate into a change in the real exchange rate if national price levels remain fixed. Intertemporal models presenting this general view include Svensson and van Wijnbergen (1989), Obstfeld andKollmann (1996).A second explanation focuses on pricing-to-market, in which a firm intentionally sets different prices for its good across segmented national markets. 4 This explanation is consistent with empirical work by Engel (1993), Knetter (1993) and others, which have documented 4 The table closely resembles standard findings in the real business cycle literature: see Backus, Kehoe, and Kydland (1992), Chari, Kehoe and McGrattan (1998a), and Chang and Devereux (1998).5 All data are logged and Hodrick-Prescott filtered quarterly series. The real exchange rate is computed as the CPI-adjusted bilateral exchange rate with the U.S. dollar. If we do not Hodrick-Prescott filter the real exchange rate data, the average serial correlation naturally is much higher: 0.94 for one quarter and 0.71 for four quarters.6 See Froot and Rogoff (1995) for a summary of the time series literature. Several studies suggest real exchange rate deviations have a half-life of about four to five years. Some studies, such as Engel (1999), cast doubt on whether the real exchange rate is even mean reverting.7 A related explanation for deviations from the law of one price, suggested in Devereux (1997), is that prices are sticky in the local currency of the buyer.

Productivity Shocks, Monetary Shocks, and the Short- and Long-run Dynamics of Exchange Rates and Relative Prices

“…May some other macroeconomic changes not considered in this study be responsible for the high persistence of the real exchange rate? How significant is the potential role of microeconomic factors (e.g., the pricing-to-market behavior examined by Bergin and Feenstra, 1999) -typically ignored by macroeconomic models of PPP deviations -in contributing to the observed persistence? These are questions warranting further investigation in future research.…”

The Wage Premium Puzzle and the Quality of Human Capital

“…6 When we use the Akaike information criterion, the results are (numbers of country-good pairs/number of lags): 113/2, 64/4, 13/1, 1/3, 13/ 5.2 7 The results for other measures of persistence are very similar.…”

“…Our paper is naturally related to the growing literature that focuses on the aggregate implications of heterogeneity in price setting. 3 It contributes to the body of work that uses dynamic sticky-price models to study the persistence of real exchange rates, such as Bergin and Feenstra (2001), Kollman (2001), Chari et al (2002), Benigno (2004), Steinsson (2008), Johri and Lahiri (2008), and Martinez-Garcia and Søndergaard (2008). There is also a connection between the results from our multi-sector model, and the …ndings of the literature on cross-sectional aggregation of time-series processes (e.g.…”

“…Woodford, chapter 3), this parameter con…guration implies a Ball and Romer (1990) index of real rigidities of roughly 0.063. The statistics presented in the table are calculated as detailed in footnote 14.36 As a consistency check, we compute the …rst-order autocorrelation of the log-change in the nominal exchange rate in each simulation of the model, and average across the 150 simulations. This results in 0.33, which compares with a cross-country average of 0.325 in theImbs et al (2005a) data used in our empirical analysis.…”

The Adjustment of Global External Balances: Does Partial Exchange Rate Pass-Through to Trade Prices Matter?

“…Our framework incorporates three complementary mechanisms that generate incomplete pass-through to trade prices. First, pass through to import prices at the dock is low because, as in Bergin and Feenstra (2001), Bouakez (2005), and Gust, Leduc, and Vigfusson (2006), firms face a non-constant elasticity of demand, which leads to optimal markup variations that reduce the sensitivity of trade prices to changes in the exchange rate. Second, the presence of nominal rigidities combined with local currency pricing also reduces the extent of pass-through at the dock.…”