Board of Governors of the Federal Reserve System

International Finance Discussion Papers
Number 845
November 2005












DSGE Models of High Exchange-Rate Volatility and Low Pass-Through


Giancarlo Corsetti, Luca Dedola, and Sylvain Leduc









NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate
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DSGE Models of High Exchange-Rate Volatility and Low Pass-Through



Giancarlo Corsetti, Luca Dedola, and Sylvain Leduc


Abstract: This paper develops a quantitative, dynamic, open-economy model which endogenously
generates high exchange rate volatility, whereas a low degree of exchange rate pass-through (ERPT)
stems from both nominal rigidities (in the form of local currency pricing) and price discrimination. We
model real exchange rate volatility in response to real shocks by reconsidering and extending two
approaches suggested by the quantitative literature (one by Backus Kehoe and Kydland [1995], the other
by Chari, Kehoe and McGrattan [2003]), within a common framework with incomplete markets and
segmented domestic economies. We show that, in our framework, both approaches are successful in
generating volatility without suffering from shortcomings such as a fall in import volatility, or the need
for nominal shocks. Our model accounts for a variable degree of ERPT over different horizons. In the
short run, we find that a very small amount of nominal rigidities --- consistent with the evidence in Bils
and Klenow [2004] --- lowers the elasticity of import prices at border and consumer level to 27% and
13%, respectively. Still, exchange rate depreciation worsens the terms of trade -- in accord with the
evidence stressed by Obstfeld and Rogoff [2000]. In the long run, ERPT coefficients are also below one,
as a result of price discrimination. We run a set of regressions adopted by the empirical literature on
ERPT, typically plagued by omitted variable bias and measurement errors, on the time series generated by
our model. The ERPT estimates are biased, but in most cases not off the mark; most regressions can
detect differences between short-run and long-run ERPT. We show that the quality of empirical proxies
for marginal costs and demand typically vary depending on the shocks (real vs. nominal) hitting the
economy.

Keywords: international business cycle, exchange rate volatility, pass-through, international transmission,
DSGE models.

JEL Classification Codes: F33, F41.








DSGE Models of High Exchange-Rate Volatility and
Low Pass-Through
1
Giancarlo Corsetti
o
European University Institute, University of Rome III and CEPR
Luca Dedola
b
European Central Bank
Sylvain Leduc
c
Federal Reserve Board
November 2005
1
Wo lhank Jon Fausl. Linoa GoloLoig. Ialiick Kohoo. H´ol`ono Ioy ano sominai pailicipanls al lho
Lank of Ioilugal. Dallas Foo. Lnlo Linauoi. Luiopoan Conlial Lank. Luiopoan Lconomic Associa-
lion. Foooial Iosoiyo Loaio. Foooial Iosoiyo Lank of Now Yoik. Lonoon School of Lconomics. Magyai
Nomzoli Lank. Uniyoisilios of Iomo ano 1oiino. lho Socioly foi Lconomic Dynamics moolings. lho
Cainogio-Mollon ano VanooiLill uniyoisily woikshop Miciooconomic Souicos of Ioal Lxchango Ialo
Lohayioi." ano lho Luiopoan Uniyoisily Inslilulo - Noilhwosloin Uniyoisily confoionco on Inlalion.
Inloiosl Ialos ano Iolaliyo Iiicos". Giancailo Coisolli`s woik on lhis papoi is pail of lho Iioiio Woinoi
Chaii in Monolaiy Union al lho LUI. 1ho yiows oxpiossoo hoio aio lhoso of lho aulhois ano oo nol
nocossaiily iolocl lho posilions of lho LCL. lho Loaio of Goyoinois of lho Foooial Iosoiyo Syslom. oi
any olhoi inslilulions wilh which lho aulhois aio amlialoo.
a
Aooioss: Via ooi Ioccollini 0. San Domonico oi Fiosolo ò0016. Ilaly: omail: Giancailo.Coisolli^iuo.il.
b
Aooioss: Ioslfach 16 018 10. D-60066 Fiankfuil am Main. Goimany: omail: luca.oooola^ocL.inl.
c
Aooioss: 20lh ano C Sliools. N.W.. Slop 48. Washinglon. DC 20òò1. USA: omail:
Sylyain.Loouc^.fiL.goy.
Abstract
1his papoi ooyolops a ouanlilaliyo. oynamic. opon-oconomy moool which onoogonously gonoi-
alos high oxchango ialo yolalilily. whoioas a low oogioo of oxchango ialo pass-lhiough (LII1)
sloms fiom Lolh nominal iigioilios (in lho foim of local cuiioncy piicing) ano piico oisciimi-
nalion. Wo moool ioal oxchango ialo yolalilily in iosponso lo ioal shocks Ly ioconsiooiing ano
oxlonoing lwo appioachos suggosloo Ly lho ouanlilaliyo liloialuio (ono Ly Lackus Kohoo ano
Kyolano [100ò[. lho olhoi Ly Chaii. Kohoo ano McGiallan [2008[). wilhin a common fiamowoik
wilh incomplolo maikols ano sogmonloo oomoslic oconomios. Wo show lhal. in oui fiamowoik.
Lolh appioachos aio succossful in gonoialing yolalilily wilhoul suloiing fiom shoilcomings such
as a fall in impoil yolalilily. oi lho nooo foi nominal shocks. Oui moool accounls foi a yaiiaLlo
oogioo of LII1 oyoi oiloionl hoiizons. In lho shoil iun. wo lno lhal a yoiy small amounl
of nominal iigioilios consislonl wilh lho oyioonco in Lils ano Klonow [2004[ lowois lho
olaslicily of impoil piicos al Loiooi ano consumoi loyol lo 27/ ano 18/. iospocliyoly. Slill.
oxchango ialo oopiocialion woisons lho loims of liaoo in accoio wilh lho oyioonco sliossoo
Ly OLslfolo ano Iogol [2000[. In lho long iun. LII1 coomcionls aio also Lolow ono. as a
iosull of piico oisciiminalion. Wo iun a sol of iogiossions aooploo Ly lho ompiiical liloialuio on
LII1. lypically plaguoo Ly omilloo yaiiaLlo Lias ano moasuiomonl oiiois. on lho limo soiios
gonoialoo Ly oui moool. 1ho LII1 oslimalos aio Liasoo. Lul in mosl casos nol ol lho maik:
mosl iogiossions can oolocl oiloioncos Lolwoon shoil-iun ano long-iun LII1. Wo show lhal
lho oualily of ompiiical pioxios foi maiginal cosls ano oomano lypically yaiy ooponoing on lho
shocks (ioal ys. nominal) hilling lho oconomy.
Koywoios: inloinalional Lusinoss cyclo. oxchango ialo yolalilily. pass-lhiough. inloinalional
liansmission. DSGL moools.
JLL Classilcalion Cooos.F88. F41.
1 Introduction
An impoilanl issuo in lho opon macio liloialuio is how lo ioconcilo high oxchango-ialo yolalilily
wilh lho slaLilily of piicos in local cuiioncy. Ono yiow sliossos nominal iigioilios: if impoil piicos
aio slicky in lho cuiioncy of lho impoiloi lho aigumonl goos laigo moyomonls in nominal
oxchango ialos will nol fully pass lhiough lo piicos. ano oxchango-ialo moyomonls musl Lo moio
pionouncoo lo Liing aLoul lho ioouiioo oouiliLiium aojuslmonl in iolaliyo piicos in iosponso lo
shocks lo funoamonlals. 1ho yiow lhal incomplolo pass-lhiough is ossonlially linkoo lo nominal
iigioilios. howoyoi. has Loon challongoo on ompiiical ano lhooiolical giounos. A laigo Looy of
Lolh micio ano macio liloialuio has aiguoo lhal. inooponoonlly of nominal fiiclions. incomplolo
oxchango ialo pass-lhiough can iosull fiom piico oisciiminalion. i.o. oplimal ooslinalion-spocilc
maikup aojuslmonl Ly lims. as woll as fiom a laigo compononl of non-liaoaLlo soiyicos ano
gooos in lho piico of lnal gooos. In lho opon macio liloialuio. OLslfolo ano Iogol [2000[ hayo
aiguoo lhal moools alliiLuling local cuiioncy piico slaLilily oxclusiyoly lo nominal iigioilios
cannol ll lho posiliyo coiiolalion Lolwoon oxchango ialos ano lho loims of liaoo (oopiocialion
woisons lho loims of liaoo) founo in lho oala. Mosl ciucially. ioconl sluoios oslimaling gonoial
oouiliLiium ouanlilaliyo moools aoopling lho aLoyo appioach. lno lhal lho oogioo of slickinoss
is unioalislically laigoi foi lho piico of impoils. lhan foi lho piico of oomoslically piooucoo
liaoaLlos a iosull suggosling misspocilcalion (o.g. soo LuLik ano Schoifhoioo [200ò[). Nolo
lhal. lakon al faco yaluo. such iosull woulo oxacoiLalo lho counloifaclual implicalions foi lho
Lohayioi of lho loims of liaoo poinloo oul Ly OLslfolo ano Iogol.
In lhis papoi. wo aooioss lho gonoial oouiliLiium link Lolwoon oxchango-ialo yolalilily ano
slaLilily of gooos piicos in a ouanlilaliyo fiamowoik which oncompassos Lolh piico oisciimi-
nalion ano nominal iigioilios. ano onoogonously gonoialos laigo swings of lho oxchango ialo in
iosponso lo shocks lo funoamonlals. 1ho liloialuio suggosls al loasl lwo appioachos lo moo-
olling onoogonous oxchango-ialo yolalilily in a ialional oxpoclalions fiamowoik: lho lisl is
puisuoo Ly Lackus. Kohoo. ano Kyolano [100ò[ which wo laLol lho olaslicily appioach lho
olhoi Ly Chaii. Kohoo ano McGiallan [2008[ which wo laLol lho iisk-ayoision appioach. Wo
ioconsiooi lhoso appioachos in a slanoaio inloinalional Lusinoss cyclo fiamowoik wilh liaooo
ano nonliaooo gooos (o.g. Slockman ano 1osai [100ò[). assuming incomplolo assol maikols
ano a ioalislic oogioo of maikol sogmonlalion. Wo show lhal lho main piopoilios of lho lwo
1
appioachos nicoly gonoializo lo oui onyiionmonl. aooiossing somo impoilanl issuos iaisoo Ly
pioyious liloialuio.
Moio piocisoly. whon puisuing lho olaslicily appioach. wo iun a sol of oxpoiimonls whoio
lho impacl of piooucliyily shocks on inloinalional piicos is magniloo Ly a iolaliyoly low piico
olaslicily of impoils. choosing paiamoloi yaluos on lho low ono of lho iango commonly aooploo
Ly lho liloialuio. In Coisolli. Dooola ano Loouc [2004[ wo hayo alioaoy shown lhal. unooi lhis
appioach. inloinalional piicos aio as yolalilo as in lho oala. In lhis papoi wo oxlono lhis iosull
lo a moool wilh piico iigioilios. Mosl impoilanl. whilo in lho LKK fiamowoik lho iosponso of
impoil ouanlilios lo shocks lonos lo fall wilh lhoii piico olaslicily. wo show lhal in oui moool
wilh incomplolo assol maikols lho impoil yolalilily is nol lowoi lhan in compaiaLlo inloinalional
DSGL moools (lhough somowhal low iolaliyo lo lho oala).
Whon puisuing lho appioach Ly Chaii. Kohoo ano McGiallan [2008[ (honcofoilh CKM).
wo oxploil lho posiliyo ano sliicl link Lolwoon lho ialio of maiginal ulililios of consumplion
ano lho ioal oxchango ialo lhal chaiacloiizos oconomios wilh complolo maikols. Wilh powoi
ulilily. if iolaliyo iisk ayoision is sumcionlly high. lho yaiiaLilily of lho ialio of Homo lo Foioign
consumplion oLsoiyoo in lho oala can coiiospono lo laigo oouiliLiium moyomonls in lho ioal
oxchango ialo. CKM omphasizo nominal iigioilios in lhoii moool. as impoil piicos aio slicky
in local cuiioncy. monolaiy shocks oo nol spill oyoi lo foioign consumplion ano show lhal
a similai mochanism woiks in a laigo class of moools wilh incomplolo maikols. A nolaLlo
iosull of lhis papoi is lo show lhal lho CKM mochanism also woiks ouilo woll in lho aLsonco
of nominal iigioilios. pioyiooo lhal lho nalional oconomios aio sumcionlly insulaloo fiom ono
anolhoi Ly lho piosonco of nonliaooo gooos. In olhoi woios. in oui moool lho CKM appioach
gonoialos oxchango ialo yolalilily in iosponso lo ioal shocks Lolh in a lox-piico ano a slicky
piico onyiionmonl.
In oilhoi sol of oxpoiimonls. oui moool allows foi maikols sogmonlalion ano ooyialions fiom
lho law of ono piico. Following Luisloin. Noyos ano IoLolo [2001[ ano Coisolli ano Dooola [200ò[.
maikol sogmonlalion in lho liaoaLlo socloi of oui oconomios is an implicalion of lho piosonco of
oisliiLulion socloi inlonsiyo in local inpuls. 1hoio aio al loasl lwo aoyanlagos in aoopling lhis
spocilcalion. Fiisl. ouo lo oisliiLulion. laigo oxchango-ialo swings oo nol lianslalo inlo laigo
CII moyomonls oyon whon all piicos aio fully loxiLlo: iolail piicos of impoiloo gooos iolocl only
a small piopoilion of moyomonls in impoil piicos al lho Loiooi. Socono. oisliiLulion soiyicos
2
inouco oiloioncos in oomano olaslicily acioss counliios. 1hus. wilh monopolislic piooucois lho
law of ono piico ooos nol holo in gonoial: in a loxiLlo piico oouiliLiium. lims woulo oplimally
chaigo oiloionl wholosalo piicos in lho oomoslic ano foioign maikols. ano woulo nol moyo
piicos ono-lo-ono wilh oxchango ialo moyomonls. Honco. whon wo allow foi nominal fiiclions
assuming lhal foioign oxpoilois faco cosls in aojusling piicos in local cuiioncios lho slaLilily
of impoil piicos in local cuiioncy ooos nol oopono oxclusiyoly on piico iigioilios.
Oui ouanlilaliyo fiamowoik yiolos lho following iosulls. Fiisl. in all oui oxpoiimonls. oui
oconomios gonoialo highly yolalilo inloinalional piicos ano can accounl foi poisislonl ano highly
coiiolaloo moyomonls in ioal ano nominal oxchango ialos. oyon foi a iolaliyoly low oogioo of
nominal iigioily oi unooi loxiLlo piicos. Whal is iomaikaLlo aLoul lhis iosull is lhal. conliaiy lo
lho piosumplion unooilying lho yasl liloialuio on lho III puzzlo omphasizing nominal shocks.
inloinalional piico yolalilily ano poisislonco aio gonoialoo Ly ioal shocks.
Socono. foi a oogioo of piico slickinoss consislonl wilh lho oyioonco in Lils ano Klonow [2004[.
i.o. assuming lhal piicos aio kopl unchangoo on ayoiago foi 4.8 monlhs. lho ioal oxchango ialo
is posiliyoly coiiolaloo wilh lho loims of liaoo ano lho piico of impoils. whilo il is only yoiy
woakly so wilh lho consumoi piico loyol. Wo slioss lhal lhis iosull is consislonl wilh lho oyioonco
omphasizoo Ly OLslfolo ano Iogol [2000[. 1hoso aulhois sliongly aiguo againsl lho hypolhosis
of local cuiioncy piicing` (honcofoilh LCI) on lho giouno lhal moools assuming il piooicl a
counloifaclual nogaliyo coiiolalion Lolwoon oxchango ialos ano loims of liaoo. Oui ouanlilaliyo
analysis shows lhal somo yoisions of LCI may aclually malch lho ompiiical oyioonco. pioyiooo
lhal lho oogioo of nominal iigioilios is nol yoiy high. Inoooo. whon wo incioaso lho ayoiago
oogioo of piico slickinoss fiom 4.8 monlhs lo 8 ouailois. lho coiiolalion Lolwoon oxchango ialos
ano loims of liaoo swilchos sign. ano Locomos nogaliyo.
1hiio. wo lno lhal a ioasonaLly small oogioo of piico slickinoss gonoialos a yoiy low oogioo
of oxchango ialo pass-lhiough in lho shoil iun. Using oui moool wo ooiiyo an oxacl (linoaiizoo)
ooualion foi impoil piicos in lho oxchango ialo. maiginal cosls in local cuiioncy. oisliiLulion
cosls ano loaos ano lags in impoil piicos oiiyon Ly oplimal foiwaio-looking piico-solling. 1his
ooualion isolalos nominal ano ioal ooloiminanls of pass-lhiough in lho shoil ano lho long iun.
In a sliucluial sonso. assuming lhal piicos aio kopl unchangoo on ayoiago foi 4.8 monlhs (onco
again. in lino wilh lho oyioonco in Lils ano Klonow [2004[). lho shoil-iun pass-lhiough coomcionl
in oui moool is as low as 0.27. 1his coomcionl falls lo 0.04 whon oui moasuio of piico slickinoss
8
is sol ooual lo 8 ouailois. Locauso of oisliiLulion. lho oxchango-ialo pass-lhough coomcionls
foi impoiloo gooos al lho consumoi-piico loyol aio half as laigo as lhoso foi impoil piicos al lho
Loioois. 1ho piooicloo olaslicily of lho oyoiall CII wilh iospocl lo oxchango ialo moyomonls is
oyon lowoi.
1hoso iosulls suggosl lhal. whilo nominal iigioilios may play an impoilanl iolo in ooloimining
a low oogioo of oxchango-ialo pass-lhiough inlo consumoi ano piooucoi piicos in lho shoil iun.
moools lhal oisiogaio nonliaoaLilily. oisliiLulion. ano piico oisciiminalion may soyoioly oisloil
lho impoilanco of nominal fiiclions.
1
In oui spocilcalion. lho magniluoo of nominal fiiclions
lo gonoialo ioalislic oogioo of pass-lhiough nooo nol Lo yoiy high. ano in any caso ioalislically
smalloi lhan in lhoso moools. Moiooyoi. consislonl wilh lho oyioonco in Gioyannini [1088[.
Maislon [1000[. ano Campa ano GoloLoig [2002[. oui moool piooicls lhal impoifocl oxchango-
ialo pass-lhiough lasls longoi lhan lho poiioo in which piicos aio slicky on ayoiago. gonoialing
long-iun ooyialions fiom lho law of ono piico. Cloaily. lhoso ooyialions cannol Lo oxplainoo Ly
moools assuming lhal incomplolo pass-lhiough is ouo oxclusiyoly lo nominal iigioilios.
Wo concluoo oui analysis Ly ioconsiooiing lho ompiiical liloialuio in lighl of oui lhooioli-
cal ano ouanlilaliyo iosulls. As is woll known. oslimalos of pass-lhiough coomcionls aio coio
inpuls in lho inlalion piojoclions lhal aio usoo in monolaiy policy oocision making. Lul oala
ayailaLilily consliains lho spocilcalion of iogiossion moools. which aio lhoiofoio plaguoo Ly
moasuiomonl oiiois ano omilloo yaiiaLlo Lias. Using oui ouanlilaliyo moool. wo can analyzo
lho implicalions of lhoso oolcioncios foi lho poifoimanco of iogiossion moools. conliolling foi
lho oconomic sliucluio ano shocks gonoialing incomplolo pass-lhiough ano oxchango ialo moyo-
monls.
Wo spocify lwo iogiossion moools lypically aooploo in lho liloialuio lhal wo ouL Iiicing
lo Maikol (I1M) ano Lxchango Ialo Iass-lhiough (LII1). Lolh iogiossion spocilcalions ioly
on pioxios of lho liuo maiginal cosls ano ignoio oisliiLulion cosls oyioonco on lho impoilanco
of lho lalloi among lho ooloiminanls of local cuiioncy piico slaLilily foi impoils is pioyiooo
Ly GoloLoig ano VoiLoyon [2001[. Lasoo on oui lhooiolical spocilcalion. wo lisl oxpioss lho
oslimalion Lias in pass-lhiough iogiossions as a funclion of (a) lho yolalilily of lho oxchango
ialo ano (L) lho coyaiianco Lolwoon lho oxchango ialo ano lho ooloiminanls of impoil piicos: a
1
We should also observe that such models typically ignore the dierent exchange rate elasticity of import prices
at the border and at the consumer level, downplaying the empirical evidence on the former.
4
high yolalilily of lho oxchango ialo lonos lo ioouco lho Lias:
2
howoyoi. sinco lho oxchango ialo
is onoogonous. lho olocls of high yolalilily on lho iogiossion Lias can Lo olsol Ly lho coyaiianco
loims. Socono. wo iun Lolh lho I1M ano lho LII1 iogiossions on lho limo soiios simulaloo
using oui moool. IomaikaLly. in oui ouanlilaliyo oxoicisos lho lwo iogiossion moools poifoim
woll in lwo oimonsions. Fiisl. in mosl casos lhoy oolocl oiloioncos in lho shoil- ano long-iun
pass-lhiough coomcionls whon lhoy aio sliucluially oiloionl. whilo solling lho lwo ooual lo
oach olhoi whon lhoy aio lho samo. Socono. lhoy pioyioo poinl oslimalos lhal. allhough Liasoo.
aio nol nocossaiily ol lho maik.
3
1ho poifoimanco of lhoso iogiossion moools cloaily oopono
on how woll lho iogiossois pioxy foi maiginal cosls ano oomano conoilions. Wo illuslialo lhis
poinl Ly showing lhal conoilioning on a oiloionl sol of shocks (ioal yoisus nominal) can chango
lho oualily of lho yaiiaLlos lypically incluooo in ompiiical analysos as pioxios foi maiginal cosls
ano oomano. causing a ioyoisal in lho ianking of alloinaliyo iogiossion moools.
1ho papoi is sliucluioo as follows. Soclion 2 will oosciiLo lho moool ano lho caliLialion
will Lo oiscussoo in Soclion 8. Wo oiscuss lho piooiclions of oui moool iogaioing lho oogioo of
oxchango-ialo pass-lhiough in Soclion 4. Wo oiscuss ompiiical moools of pass-lhiough. 1ho lasl
soclion concluoos.
2 The model
1ho woilo oconomy consisls of lwo counliios of ooual sizo. H ano 1. Lach counliy spocializos in
ono lypo of liaoaLlo gooo. piooucoo in a numLoi of yaiiolios oi Lianos oolnoo oyoi a conlinuum
of unil mass. Lianos of liaoaLlo gooos aio inooxoo Ly / ÷ [0. 1[ in lho Homo counliy ano
1 ÷ [0. 1[ in lho Foioign counliy. In aooilion. oach counliy piooucos an aiiay of oiloionlialoo
nonliaoaLlos. inooxoo Ly : ÷ [0. 1[. Nonliaooo gooos aio oilhoi consumoo oi usoo lo mako
inloimooialo liaoaLlo gooos / ano 1 ayailaLlo lo oomoslic consumois.
2
A corollary of our analysis is that models attributing exchange rate volatility to exogenous noise would simply
downplay the importance of regression bias altogether.
3
These results should be appreciated in light of the fact that in our model exchange-rate movements only
responds to shocks to demand and marginal costs, so that the covariance between these and the exchange rate
is in general dierent from zero. In other words, we are building an exercise that is not favorable to regression
specications with omitted variable bias. Moreover, we do more than studying alternative theoretical channels
through which exchange rates, marginal costs and revenues may respond to the same set of shocks | we also
provide a quantitative assessment of them.
ò
Fiims piooucing liaoaLlo ano nonliaooo gooos aio monopolislic suppliois of ono Liano of
gooos only. 1hoso lims comLino capilal wilh oiloionlialoo oomoslic laLoi inpuls in a conlin-
uum of unil mass. Lach woikoi occupios a poinl in lhis conlinuum. ano acls as a monopolislic
supplioi of a oiloionlialoo lypo of laLoi inpul lo all lims in lho oomoslic oconomy. Houso-
holos´woikois aio inooxoo Ly , ÷ [0. 1[ in lho Homo counliy ano ,

÷ [0. 1[ in lho Foioign
counliy. Fiims opoialing in lho oisliiLulion socloi. Ly conliasl. aio assumoo lo opoialo un-
ooi poifocl compolilion.
4
1hoy Luy liaoaLlo gooos ano oisliiLulo lhom lo consumois using
nonliaooo gooos as lho only inpul in pioouclion.
In oui Lasolino moool. piicos will Lo assumoo lo Lo poifoclly loxiLlo. In alloinaliyo spoc-
ilcalions. wo will inlioouco nominal piico iigioilios Ly assuming lhal lims faco a ouaoialic
cosl of aojusling gooos` piicos. In whal follows. wo oosciiLo oui sol up focusing on lho Homo
counliy. wilh lho unooislanoing lhal similai oxpiossions also chaiacloiizo lho Foioign oconomy
whoioas yaiiaLlos iofoiioo lo Foioign lims ano housoholos aio maikoo wilh an asloiisk.
2.1 The Household's Problem
2.1.1 Preferences
1ho iopiosonlaliyo Homo agonl in lho moool maximizos lho oxpocloo yaluo of hoi lifolimo ulilily.
giyon Ly:
1

1
¸
t=0
l
¸
C
t
.
'
t+1
1
t
. 1
t

oxp
¸
t1
¸
t=0
÷i

l
¸
C
t
.
'
t+1
1
t
. 1
t

¸¸
. (1)
whoio inslanlanoous ulilily l is a funclion of a consumplion inoox. C
t
. loisuio. (1 ÷ 1
t
). ano
ioal monoy Lalancos
A
t+1
1t
. 1his iocuisiyo spocilcalion of piofoioncos. accoioing lo which lho
oiscounl facloi is a funclion of pasl ulilily loyols. guaianloos lho oxislonco of a uniouo inyaiianl
oisliiLulion of woallh. inooponoonl of inilial conoilions.
5
c(
Housoholos consumo all lypos of (oomoslically-piooucoo) nonliaooo gooos. ano Lolh lypos
of liaooo gooos. So C
t
(:. ,) is consumplion of Liano : of Homo nonliaooo gooo Ly agonl , al
4
Due to this assumption, we note from the start that the equilibrium allocation studied below would be
identical in a vertically integrated economy, where exporters with monopoly power own local retailers.
5
A unique invariant distribution of wealth under these preferences will allow us to use standard numerical
techniques to solve the model around a stable nonstochastic steady state when only a non-contingent bond is
traded internationally (see Obstfeld [1990], Mendoza [1991], and Schmitt-Grohe and Uribe [2001]).
6
limo t: C
t
(/. ,) ano C
t
(1. ,) aio lho samo agonl`s consumplion of Homo Liano / ano Foioign
Liano 1. Foi oach lypo of gooo. wo assumo lhal ono Liano is an impoifocl suLslilulo foi all
olhoi Lianos. wilh conslanl olaslicily of suLslilulion 0
H
ano 0
N
1. Consumplion of Homo
ano Foioign gooos Ly Homo agonl , is oolnoo as:
C
H.t
(,) =
¸
1
0
C
t
(/. ,)

H
1

H
d/

H

H
1
. C
F.t
(,) =
¸
1
0
C
t
(1. ,)

H
1

H
d1

H

H
1
.
C
N.t
(,) =
¸
1
0
C
t
(:. ,)

N
1

N
d:

N

N
1
.
1ho full consumplion Laskol. C
t
. in oach counliy is oolnoo Ly lho following CLS aggiogaloi
C
t
=

a
1c
T
C
T.t
c
÷a
1c
N
C
N.t
c
1

. c < 1. (2)
whoio a
T
ano a
N
aio lho woighls on lho consumplion of liaooo ano nonliaooo gooos. iospocliyoly
ano
1
1 ÷c
is lho conslanl olaslicily of suLslilulion Lolwoon C
N.t
ano C
T.t
. 1ho consumplion
inoox of liaooo gooos C
T.t
is giyon Ly lho following CLS aggiogaloi
C = C
T
=

a
1a
H
C
a
H
÷a
1a
F
C
a
F
1

. j < 1. (8)
2.1.2 Budget constraints and asset markets
Homo ano Foioign agonls holo an inloinalional Lono. 1
H
. which pays in unils of Homo cuiioncy
ano is zoio in nol supply. Only oomoslic iosioonls holo lho Homo cuiioncy.'
t
. Housoholos ooiiyo
incomo fiom woiking. \
t
1
t
. fiom ionling capilal lo lims. 1
t
1
t
. fiom pioyiously accumulaloo
unils of cuiioncy. ano fiom lho piocooos fiom holoing lho inloinalional Lono. (1÷i
t
)1
H.t
. whoio
i
t
is lho nominal Lono`s yiolo. paio al lho Loginning of poiioo t in oomoslic cuiioncy Lul known
al limo t ÷1. Housoholos pay non-oisloilionaiy (lump-sum) nol laxos T. oonominaloo in Homo
cuiioncy ano uso lhoii oisposaLlo incomo lo consumo ano inyosl. 1ho inoiyioual low Luogol
consliainl foi lho iopiosonlaliyo agonl , in lho Homo counliy is lhoiofoio:
6
'
t
(,) ÷1
H.t+1
(,) _ '
t1
(,) ÷ (1 ÷i
t
)1
H.t
(,) ÷1
t
1
t
(,) (4)
÷

1
0
H(/. ,)d/ ÷

1
0
H(:. ,)d: ÷
\
t
(,)1
t
(,) ÷T
t
(,) ÷1
H.t
C
H.t
(,) ÷1
F.t
C
F.t
(,) ÷1
N.t
C
N.t
(,) ÷1
inv.t
1
t
(,)
6
BH;t denotes the Home agent's bonds accumulated during period t 1 and carried over into period t.
7
whoio c
t
is lho nominal oxchango ialo. oxpiossoo as Homo cuiioncy poi unil of Foioign cuiioncy
ano

H(/. ,)d/÷

H(:. ,)d: is lho agonl`s shaio of piolls fiom all lims / ano : in lho oconomy.
1ho piico inooxos as as follows: 1
H.t
ano 1
H.t
oonolo lho piico of lho Homo liaooo gooo al lho
producer ano consumer loyol. iospocliyoly. 1
F.t
is lho consumoi piico of Homo impoils: 1
N.t
is
lho piico of nonliaooo gooos: 1
t
is lho consumoi piico inoox.
Wo assumo lhal inyoslmonl is a CoLL-Douglas composilo of liaoaLlo ano nonliaoaLlo gooos.
in lino wilh lho oyioonco in Losma [200ò[. ano lhal lho capilal slock. 1. can Lo fiooly ioallocaloo
Lolwoon lho liaooo (1
H
) ano nonliaooo (1
N
) soclois:
1 = 1
H
÷1
N
.
Diloionl fiom lho consumplion of liaoaLlos. wo assumo lhal inyoslmonl is nol suLjocl lo oisliiL-
ulion soiyicos. lhough lho liaoaLlo compononl of il is oLlainoo lhiough lho samo CLS aggiogaloi
as lhal of consumplion. 1his way wo inlioouco in lho moool lho nolion of inloimooialo impoiloo
inpuls lhal conliiLulo lo lho foimalion of capilal in lho oconomy. 1ho law of molion foi lho
aggiogalo capilal slock is giyon Ly:
1
t+1
= 1
t
÷ (1 ÷c)1
t
÷
/
2

1
t
1
t
÷c

2
. (ò)
whoio / is an aojuslmonl cosl paiamoloi. as in CKM.
1ho housoholo`s pioLlom lhon consisls of maximizing lifolimo ulilily. oolnoo Ly (1). suLjocl
lo lho consliainls (4) ano (ò).
2.2 Firms' optimization and optimal price discrimination
Inloinalional piico oisciiminalion is a koy foaluio of lho inloinalional oconomy capluioo Ly
oui moool. In whal follows wo show lhal. oyon if Homo ano Foioign consumois hayo ioonlical
conslanl-olaslicily piofoioncos foi consumplion. lho nooo foi oisliiLulion soiyicos inlonsiyo in
local nonliaooo gooos implios lhal lho olaslicily of oomano foi lho / (1) Liano al wholosalo
loyol Lo nol gonoially lho samo acioss maikols. Fiims will lhus wanl lo chaigo oiloionl piicos al
Homo ano in lho Foioign counliy. Wo will focus oui analysis on Homo lims oplimal piicing
Ly Foioign lims can Lo oasily ooiiyoo fiom il.
8
Fiims piooucing Homo liaoaLlos (H) ano Homo nonliaoaLlos (N) aio monopolisl in lhoii
yaiioly of gooo: lhoy omploy a lochnology lhal comLinos oomoslic laLoi ano capilal inpuls.
accoioing lo lho following CoLL-Douglas funclions:
1 (/) = 7(/)1 (/)

1(/)
í
1 (:) = 7(:)1 (:)
1c
1(:)
c
.
whoio 7(/) ano 7(:) aio socloial ianoom oisluiLanco following a slalislical piocoss lo Lo
ooloiminoo Lolow. Wo assumo lhal capilal ano laLoi aio fiooly moLilo acioss soclois.
Oui spocilcalion of lho oisliiLulion socloi is in lho spiiil of lho faclual iomaik Ly 1iiolo
([100ò[. pago 17ò) lhal pioouclion ano iolailing aio complomonls. ano consumois oflon consumo
lhom in lxoo piopoilions". As in Licog ano Loyin [100ò[ ano Luisloin. Noyos ano IoLolo [2001[.
wo lhus assumo lhal Liinging ono unil of liaooo gooos lo consumois ioouiios : unils of a Laskol
of oiloionlialoo nonliaooo gooos
: =
¸
1
0
:(:)

N
1

N
d:

N

N
1
. (6)
Wo nolo hoio lhal lho Dixil-Sliglilz inoox aLoyo also applios lo lho consumplion of oiloionlialoo
nonliaooo gooos. spociloo in lho noxl suLsoclion. In oouiliLiium. lhon. lho Laskol of nonliaooo
gooos ioouiioo lo oisliiLulo liaoaLlo gooos lo consumois will hayo lho samo composilion as lho
Laskol of nonliaoaLlo gooos consumoo Ly lho iopiosonlaliyo oomoslic housoholo.
7
Wilh loxiLlo piicos. lho pioLlom of lhoso lims is slanoaio: lhoy hiio laLoi ano capilal fiom
housoholos lo maximizo lhoii piolls:
¬
t
(/) = j
t
(/) 1
t
(/) ÷\
t
1
t
(/) ÷1
t
1
t
(/)
¬
t
(:) = j
t
(:) 1
t
(:) ÷\
t
1
t
(:) ÷1
t
1
t
(:)
whoio j
t
(/) is lho wholesale piico of lho Homo liaooo gooo ano j
t
(:) is lho piico of lho
nonliaooo gooo. \
t
oonolo lho aggiogalo wago ialo. whilo 1
t
iopiosonls lho capilal ionlal ialo.
7
For simplicity, we do not distinguish between nontradable consumption goods, which directly enter the agents'
utility, and nontraded distribution services, which are jointly consumed with traded goods. This distinction may
however be important in more empirically oriented studies (e.g., see MacDonald and Ricci [2001]). By the same
token, we ignore distribution costs incurred in the non-traded good market, as these can be accounted for by
varying the level of productivity in the nontradable sector.
0
Consiooi lisl lho oplimal piicing pioLlom facoo Ly lims piooucing nonliaoaLlos foi lho
Homo maikol. 1ho oomano foi lhoii piooucl is
1(:) ÷: (:) = [j
t
(:)[
0
N
1
0
N
N.t
¸
1
N.t
÷:

1
0
1
t
(/)d/ ÷

1
0
1
t
(1)d1

. (7)
whoio 1
N.t
is lho (consumplion ano inyoslmonl) aggiogalo oomano foi non-liaooo gooos. Il is
oasy lo soo lhal lhoii oplimal piico will iosull fiom chaiging a conslanl maikup oyoi maiginal
cosls:
j
t
(:) = 1
N.t
=
0
N
0
N
÷1
'C
N.t
= 1
N.t
=
0
N
0
N
÷1
\
c
t
1
1c
t
7
N,t
(8)
Now. lol j
t
(/) oonolo lho piico of Liano / oxpiossoo in lho Homo cuiioncy. al producer loyol.
Wilh a compoliliyo oisliiLulion socloi. lho consumoi piico of gooo / is simply
j
t
(/) = j
t
(/) ÷:1
N.t
. (0)
In lho caso of lims piooucing liaoaLlos. piicing lo maikol" ooiiyos onoogonously fiom lho
solulion lo lho pioLlom of lho Homo iopiosonlaliyo lim in lho socloi:
'ar
j(I). j

(I)
[ ¯ j
t
(/)1
t
(/) ÷c
t
¯ j

t
(/)1

t
(/)[ ÷
\
í
t
1

t
7
H.t
[1
t
(/) ÷1

t
(/)[ (10)
whoio
1
t
(/) =

1
H.t
¯ j
t
(/) ÷:1
N.t

0
H
C
H.t
. 1

t
(/) =

1

H.t
¯ j

t
(/) ÷:1

N.t

0

H
C

H.t
. (11)
Making uso of (8). lho oplimal wholosalo piicos foi lho consumplion gooo ¯ j(/) ano ¯ j

(/) aio:
¯ j
t
(/) =
0
H
0
H
÷1

1 ÷
:
0
H
0
N
0
N
÷1
7
H.t
7
N.t
\
c
t
1
1c
t
\
í
t
1

t

\
í
t
1

t
7
H.t
= :/
H.t
\
í
t
1

t
7
H.t
. (12)
c
t
¯ j

(/) =
0

H
0

H
÷1

1 ÷
:
0

H
0

N
0

N
÷1
7
H.t
7

N.t
c
t
\
c
t
1
1c
t
\
í
t
1

t

\
í
t
1

t
7
H.t
= :/
H

.t
\
í
t
1

t
7
H.t
.
(18)
whoio c
t
is lho nominal oxchango ialo. oxpiossoo in unils of homo cuiioncy unils. ano :/
H.t
ano :/
H

.t
oonolo lho maikups. Unliko lho caso of nonliaooo gooos (8). in lhis caso lho
maikups chaigoo Ly lho Homo lims incluoo a slalo-conlingonl compononl in Liackols in
10
lho aLoyo oxpiossion lhal yaiios as a funclion of piooucliyily shocks. monolaiy innoyalions
(alocling lho oxchango ialo) ano iolaliyo wagos. Sinco in gonoial :/
H.t
will nol ooual :/
H

.t
.
oyon whon 0

H
= 0
H
. lho oplimal wholosalo piico of liaoaLlo gooos will nol oLoy lho law of
ono piico (¯ j
t
(/) = c
t
¯ j

t
(/)). 1his iosull iolocls lho oiloionco in lho olaslicily of oomano facoo
Ly lho upslioam monopolisl al Homo ano aLioao Lioughl aLoul Ly any asymmoliy in iolaliyo
piooucliyily ano´oi facloi piicos.
Finally. nolico lhal sinco lhoio aio no oisliiLulion cosls in inyoslmonl. lho loxiLlo piico of lho
inyoslmonl gooos will Lo ooual lo lho slanoaio oxpiossion wilhoul slalo conlingonl compononl
of maikups.
Sticky Prices 1o sluoy lho impacl of local cuiioncy piicing on lho oogioo of oxchango-ialo
pass-lhiough. in alloinaliyo spocilcalions of oui Lonchmaik moool wo allow foi lho possiLilily
lhal gooos piicos aio slicky. Following IolomLoig [1082[ ano Dooola ano Loouc [2001[. lims in
lho liaooo ano non-liaooo gooos soclois aio assumoo lo faco a ouaoialic cosl whon aojusling
lhoii piicos (cosls which aio sol ooual lo zoio in sloaoy slalo). Fiims oo nol faco piico-aojuslmonl
cosls in sloaoy slalo. Fiims pay lhis aojuslmonl cosl Ly puichasing a CLS aggiogaloo Laskol
of all lho gooos in lhoii socloi of lho oconomy. 1ho piico-aojuslmonl cosls facoo Ly lims in lho
liaooo ano non-liaooo gooos socloi aio iospocliyoly:
¹C
j
H.t
(/) =
i
j
H
2

¯ j
t
(/)
¯ j
t1
(/)
÷¬

2
1
H.t
. ¹C
j
H.t
(/) =
i
j
H
2

¯ j

t
(/)
¯ j

t1
(/)
÷¬

2
1
H.t
.
ano
¹C
j
t
(:) =
i
j
N
2

j
t
(:)
j
t1
(:)
÷¬

2
1
N.t
.
Sinco lims piooucing liaooo gooos can piico oiloionlly accoioing lo lho ooslinalion maikol.
lhoy incui a cosl whon lhoy chango piicos in oilhoi lho Homo oi lho Foioign maikol. Nolo lhal.
ialhoi innocuously. wo assumo lhal Lolh ¹C
j
H.t
(/) ano ¹C
j
H.t
(/) aio oonominaloo in unils of
oomoslic liaooo gooos.
2.2.1 Price indexes
A nolaLlo foaluio of oui spocilcalion is lhal. Locauso of oisliiLulion cosls. lhoio is a woogo
Lolwoon lho piooucoi piico ano lho consumoi piico of oach gooo. Wilh compoliliyo lims in lho
oisliiLulion socloi. lho consumoi piico of lho Homo liaooo gooo 1
H.t
is simply lho sum of lho
11
piico of Homo liaooo gooos al piooucoi loyol 1
H.t
ano lho yaluo of lho nonliaooo gooos lhal
aio nocossaiy lo oisliiLulo il lo consumois
1
H.t
= 1
H.t
÷:1
N.t
. (14)
Wo hoioafloi wiilo lho piico inoox of liaoaLlos ano lho ulilily-Lasoo CIIs:
1
T.t
=

a
H
1
H.t

1
÷a
F
1
F.t

1

1

1
t
=
¸
a
T
1
T.t

1
÷a
N
1
N.t

1
1

.
Foioign piicos. oonoloo wilh an asloiisk ano oxpiossoo in lho samo cuiioncy as Homo piicos. aio
similaily oolnoo. OLsoiyo lhal lho law of ono piico holos al lho wholosalo loyol Lul nol al lho
consumoi loyol. so lhal 1
H.t
= 1

H.t
Lul 1
H.t
= 1

H.t
.
3 Calibration
1aLlo 1 iopoils oui Lonchmaik caliLialion. which wo assumo symmoliic acioss counliios. Soyoial
paiamoloi yaluos aio slanoaio in lho inloinalional Lusinoss cyclo liloialuio. o.g. similai lo lhoso
aooploo Ly Slockman ano 1osai [100ò[. who caliLialo lhoii moools lo a sol of OLCD counliios.
ano CKM. 1hioughoul lho oxoiciso. wo will caiiy oul somo sonsiliyily analysis ano assoss lho
ioLuslnoss of oui iosulls unooi lho Lonchmaik caliLialion.
Productivity shocks Lol lho yocloi Z = ¦7
;
. 7

;
¦ iopiosonl socloi j`s lochnology shocks in
lho oomoslic ano foioign oconomios. Wo assumo lhal socloial oisluiLancos lo lochnology follow
a liono-slalionaiy AI(1) piocoss
Z
0
= Z ÷u. (1ò)
whoioas u = (n
;
. n

;
) has yaiianco-coyaiianco maliix \ (u). ano is a 2r2 maliix of coomcionls
oosciiLing lho aulocoiiolalion piopoilios of lho shocks. lhal aio lho samo foi Lolh socloial
shocks. Sinco wo assumo a symmoliic oconomic sliucluio acioss counliios. wo also imposo
symmoliy on lho aulocoiiolalion ano yaiianco-coyaiianco maliicos of lho aLoyo piocoss. Locauso
of lack of socloial oala on piooucliyily. wo posil lhal socloial shocks follow a simplo ano ialhoi
12
conyonlional piocoss.
8
Fiisl. in lino wilh mosl of lho inloinalional Lusinoss cyclo liloialuio
o.g.. LKK wo assumo lhal lhoso shocks aio yoiy poisislonl. ano sol lhoii aulocoiiolalion lo
0.0ò. Socono. lho slanoaio ooyialion of lho innoyalions is sol lo 0.007 ano lhoii coiiolalion
acioss counliios lo 0.2ò. whilo lho coiiolalion acioss soclois is sol lo zoio (soo Lollom panol
of 1aLlo 1). Finally. wo assumo lhal lhoio aio no spilloyois acioss counliios ano soclois. As
a consoouonco of lhis choico. il can Lo anlicipaloo lhal lho moool will hayo a haio limo in
ioplicaling lho palloin of inloinalional comoyomonls. foi which sizaLlo shock coiiolalions aio
ioouiioo. 1hus. in juoging lhis aspocl of lho moool wo will focus on ono moaningful slalislic.
lho oiloionco Lolwoon lho cioss-coiiolalions of oulpul ano consumplion. which. as aiguoo Ly
LKK. is a gooo inoicaloi of lho aLilily of a moool lo gonoialo a liansmission mochanism lhal
can oscapo lho ouanlily puzzlo."
Monetary policy In chaiacloiizing monolaiy policy. wo assumo lhal in lho Lonchmaik sys-
lomalic policy follows a 1ayloi-lypo iulo solling lho shoil-loim nominal inloiosl ialo as a func-
lion of lho ooyialions of oxpocloo inlalion ano GDI fiom sloaoy slalo yaluos:
1
t
= j1
t1
÷.(1 ÷j)1(¬
t+1
÷¬
cc
) ÷(1 ÷j)(n
t
÷n
cc
). (16)
Wo paiamoloiizo lho policy iulo using lho oslimalos in LuLik ano Schoifhoioo [2004[: j = 0.84.
. = 2.10. = 0.8. 1o omphasizo lhal oui iosulls oo no oopono on monolaiy shocks. in lho
oxoicisos iopoiloo Lolow wo assumo lhal lhoio is no slochaslic compononl lo monolaiy policy.
Wo oLsoiyo hoio lhal oui iosulls aio unchangoo whon wo aoo plausiLlo monolaiy shocks. Liko-
wiso. wo oocumonl lhal oui iosulls iomain laigoly unchangoo whon wo assumo lhal syslomalic
monolaiy policy is such lhal monoy giowlh iomains conslanl al lho sloaoy slalo loyol (k-iulo).
oi cuiionl inlalion is poifoclly slaLilizoo (inlalion-laigoling iulo).
Preferences and production Wo posil lhal lho poiioo-Ly-poiioo ulilily funclion has lho
following foim:
l
¸
C
t
.
'
t+1
1
t
. /
t

=
C
1o
t
1 ÷o
÷.

A
t+1
1t

1o
1 ÷o
÷c
(1 ÷/
t
)
1u
1 ÷·
. o 0. (17)
8
In Corsetti, Dedola and Leduc [2004] we estimated this vector process with annual data, the only frequency
for which sectoral productivity is available for several OECD countries. If we use a quarterly version of that
process we get broadly similar results to those reported here.
18
wo sol c so lhal in sloaoy slalo. ono lhiio of lho limo onoowmonl is sponl woiking. In oui
Lonchmaik caliLialion. wo sol · ooual lo o (iisk ayoision). Sinco lho ulilily funclion is sopaiaLlo
in consumplion ano ioal monoy Lalancos. monoy oomano is ooloiminoo iosioually ano ooos nol
play any iolo in oui iosulls. Wo lhoiofoio sol . aiLiliaiily lo 0.1. Following Schmill-Gioho
ano UiiLo [2001[. wo assumo lhal lho onoogonous oiscounl facloi ooponos on lho ayoiago poi
capila loyol of consumplion. C
t
. ioal monoy Lalancos.
A
t+1
1t
. ano houis woikoo. /
t
. ano has lho
following foim:
i

l
¸
C
t
.
'
t+1
1
t
. /
t

=

ln

1 ÷c

C
t
÷.
A
t+1
1t
÷c(1 ÷/
t
)

o = 1
ln

1 ÷c

lnC
t
÷.ln
A
t+1
1t
÷cln(1 ÷/
t
)

o = 1
.
whoioas c is choson such lhal lho sloaoy-slalo ioal inloiosl ialo is 1 poiconl poi ouailoi. i.o.
ooual lo 0.006. 1his paiamoloi also pins oown lho (yoiy low) spooo of conyoigonco lo lho
nonslochaslic sloaoy slalo.
1ho yaluo of c is solocloo Lasoo on lho ayailaLlo oslimalos foi lho olaslicily of suLslilulion
Lolwoon liaooo ano nonliaooo gooos. Wo uso lho oslimalo Ly Monooza [1001[ iofoiioo lo a
samplo of inousliializoo counliios ano sol lhal olaslicily ooual lo 0.74. a yaluo on lho highoi sioo
of lhoso oslimaloo.
Accoioing lo lho oyioonco foi lho U.S. oconomy in Luisloin. Noyos ano IoLolo [2008[. lho
shaio of lho iolail piico of liaooo gooos accounloo foi Ly local oisliiLulion soiyicos iangos Lo-
lwoon 40 poiconl ano ò0 poiconl. ooponoing on lho inousliial socloi. Wo follow lhoii caliLialion
ano sol il ooual lo ò0 poiconl.
As iogaios lho woighls of oomoslic ano foioign liaoaLlos in lho liaoaLlos consumplion Laskol
(C
t
). a
h
ano a
f
(noimalizoo a
h
÷ a
f
= 1) aio choson such lhal impoils aio 10 poiconl of
aggiogalo oulpul in sloaoy slalo. ioughly in lino wilh lho ayoiago ialio foi lho U.S. in lho lasl
80 yoais. 1ho woighls of liaooo ano nonliaooo gooos. a
t
ano a
n
. aio choson as lo malch lho
shaio of nonliaoaLlos (i.o. soiyicos) in lho U.S. consumplion Laskol. which is aiouno ò0 poiconl
whon onoigy gooos aio oxcluooo. 1ho woighls of liaoaLlos ano nonliaoaLlos inpuls in capilal
foimalion aio sol lo 0.4 ano 0.6. iospocliyoly. in lino wilh lho oyioonco in Losma [200ò[.
Duo lo lack of Lolloi oyioonco. wo caliLialo : ano c. lho laLoi shaios in lho pioouclion
of liaoaLlos ano nonliaoaLlos. Lasoo on lho woik of Slockman ano 1osai [100ò[. 1hoy calcu-
lalo lhoso shaios lo Lo ooual lo 61 poiconl ano ò6 poiconl. iospocliyoly. Finally. wo sol lho
oopiocialion ialo of capilal ooual lo 10 poiconl annually.
14
A koy iolo in oui moool is playoo Ly lho maikup in lho liaoaLlo socloi. Nolo. howoyoi.
lhal in lho piosonco of oisliiLulion cosls. lho socloial maikups will nol Lo ooual in sloaoy slalo
acioss soclois foi symmoliic yaluos of 0
H
ano 0
N
. In lho nonliaooo-gooos socloi. lho maikup is
lho slanoaio
0
N
0
N
1
. In lho liaooo-gooo socloi. lho maikup is:
:/
h
=
0
h
0
h
÷1

1 ÷
:
0
h
0
n
0
n
÷1
'C
n
'C
h

.
whoio 'C
n
ano 'C
h
aio lho maiginal cosls in lho non-liaooo ano liaooo-gooos socloi. io-
spocliyoly. Wo sol lho gioss sloaoy-slalo maikup foi oomoslic gooos lo 1.1ò. 1his implios lhal
0
n
(ano 0

n
) is ooual lo 7.7. Wo lhon paiamoliizo lho olaslicily of suLslilulion of liaooo gooos
yaiiolios. 0
h
ano 0
f
. so lhal lho sloaoy-slalo maikup is ioonlical acioss soclois. foi lho giyon
caliLialoo yaluo of lho oisliiLulion maigin.
In oui spocilcalion wilh nominal piico iigioily. wo caliLialo lho piico-aojuslmonl cosl paia-
molois. c
h
ano c
n
. Ly noling lhal a lypical Calyo piico-solling moool implios a (log-linoaiizoo)
slochaslic oiloionco ooualion foi inlalion of lho foim ¬
t
= 1
t
¬
t+1
÷
¯
`:c
t
. whoio :c
t
is lho
lim`s ioal maiginal cosl of pioouclion. ano
¯
` =
(1o)(1oo)
o
. wilh c Loing lho conslanl pioLaLil-
ily lhal a lim musl koop ils piico unchangoo in any giyon poiioo ano lho oiscounl facloi (soo
Gal´i ano Goilloi [1000[). 1ho ouaoialic aojuslmonl-cosl moool giyos a similai (log-linoaiizoo)
oiloionco ooualion foi inlalion. Lul wilh
¯
` =
0
J
÷1
i
j
J
¬
2
. J=H,N. In lino wilh lho oyioonco io-
poiloo Ly Lils ano Klonow [2004[ foi lho U.S.. showing lhal lho ayoiago ouialion Lolwoon piico
changos is 4.8 monlhs. wo sol lho yaluos of i
j
H
. i
j
H
. ano i
j
N
ooual lo 8.6. 8.7. ano 4.0. iospoc-
liyoly. 1hoso yaluos imply lhal lho iooucoo foim coomcionl mulliplying ioal maiginal cosls ` is
lho samo acioss all gooos. Moiooyoi. wo also simulalo oui moool assuming lhal piicos aio sol
foi lhioo ouailois. sinco lhis is a yaluo commonly usoo in lho slicky-piico liloialuio. Nolo also
lhal in lho oxpoiimonls Lolow. wo hayo aLsliacloo fiom wago slickinoss. allhough il may Lo an
impoilanl ooloiminanl of lho iosponso (oi lack lhoioof) of consumoi piicos lo oxchango ialos.
Setting the elasticity of substitution between Home and Foreign tradables and risk
aversion ALoyo. wo hayo oiscussoo lho sol of paiamolois whoso caliLialion will iomain ioonli-
cal acioss oui oxpoiimonls. oi yaiy only foi ioLuslnoss chocks. Wo now oiscuss paiamolois which
play a ciucial iolo in oiloionlialing Lolwoon lho lwo appioachos lo moooling ioal oxchango ialo
yolalilily suggosloo Ly lho DSGL liloialuio. lhal wo follow in oui ouanlilaliyo oxoicisos.

1ho focus of lho iisk-ayoision appioach.` puisuoo Ly CKM. is on lho sliicl posiliyo link
Lolwoon iolaliyo consumplion ano lho ioal oxchango ialo in complolo maikol oconomios. as
woll as in a laigo class of oconomios wilh incomplolo maikols. Wilh powoi ulilily. if iolaliyo
iisk ayoision is sumcionlly high. lho yaiiaLilily of lho ialio of Homo lo Foioign consumplion
oLsoiyoo in lho oala can coiiospono lo laigo oouiliLiium moyomonls in lho ioal oxchango ialo.
Wo ioconsiooi lho CKM moooling slialogy in a oiloionl fiamowoik. incluoing nonliaoaLlos
ano oisliiLulion cosls which cioalo maikols sogmonlalion ano ooyialion fiom lho law of ono
piico. oyon in lho aLsonco of nominal iigioilios. In oui sol of oxpoiimonls. following CKM. wo
will sluoy an oconomy in which o = ò. solling lho inyoslmonl aojuslmonl cosl. /. lo malch
lho slanoaio ooyialion of consumplion iolaliyo lo lhal of oulpul in lho Uniloo Slalos. 1ho
olaslicily of suLslilulion Lolwoon impoiloo ano oomoslic liaoaLlos in Lolh consumplion ano
lho inloimooialo inpul lo inyoslmonl. .. is sol lo 1.ò.
1ho olaslicily appioach` has Loon oiscussoo oaily on Ly LKK in lho fiamowoik of a complolo
maikol moool. ano ioconlly ioconsiooioo in a moool wilh incomplolo maikols in pioyious woik of
ouis (Coisolli. Dooola ano Loouc [2004[).
9
1ho iooa is lhal lho impacl of shocks on inloinalional
piicos is magniloo Ly a iolaliyoly low piico olaslicily of impoils wilhin lho iango of yaluos
aooploo Ly lho liloialuio. Following lhis appioach. wo also sluoy an oconomy in which wo sol
o = 2 ano . = 0.ò.
10
Unooi lho olaslicily appioach. wo caliLialo lho inyoslmonl aojuslmonl
cosl. /. lo malch lho slanoaio ooyialion of U.S. inyoslmonl iolaliyo lo lhal of U.S. oulpul.
9
In (Corsetti, Dedola and Leduc [2004]), we show that the volatility of international prices is hump-shaped in
!, and thoroughly discussed the mechanism underlying this pattern.
10
There is considerable uncertainty regarding the true value of trade elasticities, directly related to this para-
meter. For instance, Taylor [1993] estimates the value for the U.S. to be 0.39, while Whalley [1985], in the study
used by Backus et al. [1995], reports a value of 1.5. For European countries most empirical studies suggest a
value below 1. For instance, Anderton et al. (2004) report values between 0.5 and 0.81 for the Euro area. In
ongoing work, we have found that introducing preferences and technology in which the short-run and long-run
elasticity of substitution across tradables dier, with the former being lower than the latter, as in Cooley and
Quadrini [2003], may allow us to obtain very similar results to those reported thereafter, while keeping the long
run elasticity equal to the traditional value of 1.5.
16
4 Business cycle properties of exchange rates and prices
Wo iopoil lho H-Illloioo slalislics foi lho oala ano foi oui oconomios wilh loxiLlo piicos
ano oiloionl oogioos of nominal iigioilios in 1aLlos 2A-2L. 1aLlos 8A ano 8L. insloao. iopoil
iosulls foi lho caso of a low oogioo of piico slickinoss wilh oiloionl monolaiy iulos: 1ayloi. monoy
giowlh ano inlalion laigoling. 1aLlos 2A ano 8A iofoi lo lho spocilcalion wilh a iolaliyoly low
olaslicily. whilo 1aLlos 2L ano 8L iofoi lo lho paiamoliizalion wilh a high iisk ayoision. 1ho
ompiiical slalislics aio all compuloo wilh lho Uniloo Slalos as lho homo counliy ano lho iosl of
lho woilo as lho foioign counliy.
11
Slanoaio ooyialions aio noimalizoo Ly lho slanoaio ooyialion
of U.S. oulpul. 1hioughoul oui oxoicisos. wo lako a lisl-oiooi 1ayloi soiios oxpansion aiouno
lho ooloiminislic sloaoy slalo ano solyo oui moool oconomy using lho DYNAIL algoiilhm. Wo
compulo lho moool`s slalislics Ly logging ano llloiing lho moool`s aililcial limo soiios using
lho Hooiick ano Iioscoll llloi ano ayoiaging momonls of a long limo-soiios simulalion of òò00
poiioos. of which wo oiscaio lho lisl ò00 oLsoiyalions.
Consiooi lisl 1aLlo 2. Lach panol (A ano L) of lho laLlo iopoils lho iosulls fiom lhioo
yoisions of lho moool: a loxiLlo-piico oconomy. ano lwo oconomios wilh low ano high oogioo of
local cuiioncy piico slickinoss (LCI). ooual lo 1.48 ano 8 ouailois. iospocliyoly. Oyoiall. wo lno
lhal lho oconomios oisplayoo in 1aLlos 2A ano 2L oisplay a sliiking aLilily lo accounl Lioaoly
foi lho main foaluios of oxchango ialos ano inloinalional piicos in lho oala: inloinalional piico
moyomonls aio yolalilo. poisislonl. ano highly coiiolaloo a gooo oualilaliyo malch of lho
oala. Moiooyoi. lho coiiolalion of lho nominal oxchango ialo wilh consumoi piicos is gonoially
low. 1ho lwo oconomios in 1aLlo 2A ano 2L. howoyoi. oiloi in ono impoilanl iospocl. i.o. lhoii
aLilily lo malch lho coiiolalion Lolwoon inloinalional piicos ano ouanlilios. 1ho oconomy wilh
a low olaslicily in 1aLlo 2A can accounl foi lho nogaliyo coiiolalion Lolwoon iolaliyo consump-
lion ano lho ioal oxchango ialo oLsoiyoo in lho oala. aooiossing lho so-calloo Lackus-Smilh
anomaly.
12
1ho mochanism unooilying lhis iosull is lhal. whon lho piico-olaslicily of impoils is
11
Thus, import and export prices, the CPI and so on are from U.S. data, while the real exchange rate, for
example, refers to the trade-weighted exchange rate for the United States (deated with CPIs) relative to its
trading partners, based on data reported by the OECD and the IMF.
12
The analysis of a similar economy with exible prices is fully developed in Corsetti Dedola and Leduc [2004].
Relative to the exible prices benchmark, in this paper we highlight that this important feature of our model also
characterizes specications with nominal price rigidities.
17
sumcionlly low. oouiliLiium inloinalional iolaliyo piicos moyomonls aoo lo consumplion iisk. In
pailiculai. following a posiliyo lochnology shock in Homo liaoaLlos. lho loims of liaoo (ano lho
ioal oxchango ialo) appiocialo. iooucing iolaliyo woallh ano consumplion aLioao.
13
Conyoisoly.
moools of oxchango ialo yolalilily iolying on lho mochanism highlighloo Ly CKM piooicl a yii-
lually poifocl coiiolalion Lolwoon iolaliyo consumplion ano lho ioal oxchango ialo. a foaluio
lhal is al ooos wilh lho oala. 1his is liuo in oui oxpoiimonls as woll. as iopoiloo in 1aLlo 2L.
Nonolholoss. wo slioss lhal lho mochanism pioposoo Ly CKM lo gonoialo yolalilily woiks ouilo
woll in oui fiamowoik. iiiospocliyo of nominal iigioilios. in iosponso lo ioal shocks.
1ho following iosulls omoigo. Fiisl. lho yolalilily of lho nominal oxchango ialo ano inloi-
nalional piicos is as high oi oyon highoi lhan in lho oala foi Lolh paiamoloiizalions. OLsoiyo
lhal lho aooilion of piico slickinoss inoooo lonos lo amplify lho yolalilily of oxchango ialos. Lul
whilo iaising lho oogioo of nominal iigioilios makos inloinalional piicos moio yolalilo unooi lho
olaslicily appioach. lho iolalionship Lolwoon piico slickinoss ano yolalilily is non linoai unooi
lho iisk ayoision appioach.
Socono. foi a oogioo of nominal iigioily consislonl wilh lho oyioonco in Lils ano Klonow
[2004[. wo lno lhal lho ioal oxchango ialo is posiliyoly coiiolaloo wilh Lolh lho nominal oxchango
ialo ano lho loims of liaoo (a woakoi cuiioncy is associaloo wilh a woisoning of lho loims of
liaoo). Iosiliyo comoyomonls Lolwoon lho oxchango ialo ano lho loims of liaoo aio sliossoo
Ly OLslfolo ano Iogol [2000[ as oyioonco againsl lho iooa lhal impoil piicos in local cuiioncy
oo nol ioacl lo oxchango ialos. Locauso of nominal iigioilios. In lighl of lho ooLalo following
OLslfolo ano Iogol [2000[. wo pioyioo an impoilanl oualilcalion lo lhoii aigumonl. In a moool
whoio lims faco cosls of aojusling piicos in local cuiioncy. lho coiiolalion Lolwoon lho loims of
liaoo ano lho oxchango ialo ooponos on lho oogioo of nominal iigioilios. In oui solup. piicos can
chango in lho poiioo in which lims aio hil Ly a shock. pioyiooo lhoy lno il conyonionl lo Loai lho
aojuslmonl cosls. Honco. in conliasl lo lho onyiionmonl aooploo Ly OLslfolo ano Iogol [2000[.
13
Because of home bias in consumption, domestic tradables are mainly demanded by domestic households.
With a low price elasticity, a terms-of-trade depreciation that reduces domestic wealth relative to the rest of the
world would actually result in a drop of the world demand for domestic goods | the negative wealth eect in the
home country would more than oset any global positive substitution and wealth eect. Therefore, for the world
markets to clear, a larger supply of domestic tradables must be matched by an increase in their relative price,
that is, an appreciation of the terms of trade | driving up domestic wealth and demand (see Corsetti, Dedola,
and Leduc [2004] for details).
18
in which piicos aio piosol foi ono poiioo. oui moool ooos nol piooicl lhal a oopiocialion will
aulomalically impioyo lho loims of liaoo. unloss lho aojuslmonl cosl is iolaliyoly high. Inoooo.
as shown in Lolh 1aLlos 2A ano 2L. lho coiiolalion Lolwoon lhoso lwo yaiiaLlos swilchos fiom
posiliyo lo nogaliyo whon wo iaiso lho oogioo of nominal iigioilios (soo lho lasl lwo columns in
lho laLlos).
1hiio. liaoilional moools wilh piico iigioilios ano high pass-lhiough piooicl lhal lho coiio-
lalion Lolwoon lho oxchango ialo ano lho impoil piico inoox is almosl poifocl: a oopiocialion
of lho cuiioncy lianslalos inlo impoiloo inlalion" foi lho oomoslic oconomy appioximaloly
ono-lo-ono. In oui simulalions. insloao. lho aLoyo coiiolalion is posiliyo Lul much Lolow ono.
as in lho oala: in 1aLlo 2A lho highosl coiiolalion is 0.01 (foi lho loxiLlo piico oconomy). lho
lowosl coiiolalion is 0.60 (foi lho oconomy wilh 8-ouailoi piico iigioilios). againsl 0.4ò in lho
oala (oxcluoing oil impoils). Along lhis oimonsion. lho spocilcalion of 1aLlo 2L is closoi lo lho
oala ospocially foi lho low LCI caso.
Fouilh. a low (onoogonous) impoil piico olaslicily ano oisliiLuliyo liaoo imply lhal consumoi
piicos aio only lonuously coiiolaloo wilh lho nominal oxchango ialo acioss all spocilcalions
Lioaoly in accoio lo lho oyioonco. In pailiculai. lho coiiolalion wilh lho CII (oxcluoing onoigy)
acioss all spocilcalions wilh nominal iigioilios is low Lul gonoially posiliyo in loyols. againsl
-0.17 in lho oala.
Fiflh. whilo in Lolh panols of 1aLlo 2 lho iolaliyo yolalilily of impoils is ouilo high (a iosull
ospocially iomaikaLlo foi lho paiamoloiizalion wilh a low .). il falls shoil of lhal in lho oala
foi all spocilcalions.
Finally. wo oLsoiyo lhal lho oconomios in 1aLlo 2A aio consislonl wilh lho facl lhal nol ox-
poils aio counloicyclical (a foaluioo of lho oala omphasizoo in lho inloinalional Lusinoss cyclo
liloialuio) ano lhal lho cioss-counliy coiiolalion of oulpul is laigoi lhan lhal of consumplion
(i.o. lhoy aooioss lho so-calloo ouanlily puzzlo`). Unooi lho olaslicily appioach. nol oxpoils
aio counloicyclical Locauso posiliyo piooucliyily shocks in lho Homo liaoaLlo socloi iaisos lhoii
inloinalional piico (i.o. lho loims of liaoo appiocialos). lowoiing nol oxpoils. In conliasl. un-
ooi lho iisk-ayoision appioach. piooucliyily impioyomonls in lho Homo liaoaLlos causo lhoii
inloinalional piico lo fall. iaising nol oxpoils. Whon wo assumo a low liaoo olaslicily. consump-
lion iisk shaiing is low. consislonl wilh a nogaliyo Lackus-Smilh coiiolalion. Likowiso. unooi
lho olaslicily appioach lho moool is nol suLjocl lo lho ouanlily puzzlo. as lho cioss-counliy
10
coiiolalion of oulpul is highoi lhan lhal of consumplion.
In 1aLlos 8A ano 8L. wo luin lo oxpoiimonls losling lho sonsiliyily of oui iosulls lo oif-
foionl monolaiy policy iulos. Oyoiall. lhoso laLlos show lhal lho iosulls oiscussoo aLoyo aio
Lioaoly inooponoonl of lho pailiculai monolaiy policy ioaclion funclion assumoo in oui ox-
oicisos. 1ho oualilaliyo foaluios of oui moool Loing suLslanlially unalocloo. oiloionl policy
ioaclion funclions mainly impingo on lho ouanlilaliyo piopoilios of nominal yaiiaLlos. Namoly.
in oui ouanlilaliyo iosulls. lho CII Locomos piogiossiyoly smoolhoi whon wo moyo fiom lho
k-poiconl iulo lo oui Lonchmaik spocilcalion of monolaiy policy iulos (1ayloi). ano fiom lhis
lo inlalion laigoling. Wilh a smoolhoi palh foi lho consumoi piico. lho nominal oxchango ialo
lonos lo Locomo moio similai lo lho ioal oxchango ialo. Unooi inlalion laigoling (lasl column
in oach panol of 1aLlo 8). lho yolalilily of lho lwo yaiiaLlos is lho samo. ano lhoii coiiolalion is
poifocl.
In 1aLlo 8L (lho oconomy wilh high iisk ayoision). wo can oolocl a socono implicalion of
yaiying monolaiy iulos. In lhis oconomy. making monolaiy policy moio iosponsiyo lo luclua-
lions in inlalion iaisos lho coiiolalion Lolwoon lho CII ano lho nominal oxchango ialo. Wilh
inlalion laigoling. such coiiolalion is as high as 0.68. againsl 0.1ò in lho Lonchmaik. In lhis oi-
monsion. lho low-olaslicily oconomy of 1aLlo 8A ooos Lolloi: whon monolaiy aulhoiilios puisuo
inlalion laigoling. lho piooicloo coiiolalion is -0.2ò. againsl -0.17 in lho oala.
5 Structural and empirical pass-through equations
Lxchango ialo pass-lhiough (honcofoilh LII1) is oolnoo as lho poiconlago chango in impoil
piicos oonominaloo in local cuiioncy iosulling fiom a ono poiconl chango in lho Lilaloial ox-
chango ialo Lolwoon lho oxpoiling ano lho impoiling counliy. other things equal.
14
In lhis
soclion. wo ooiiyo sliucluial oxpiossions foi pass-lhiough coomcionls in lho shoil- ano lho long-
14
Textbook models of the balance of payments, as well as a host of papers in the New open-economy macro-
economics literature, assume a one-for-one response of import prices to exchange rates, namely full or complete
ERPT. Notably, complete ERPT obtains if markups over costs are constant. Under complete ERPT, the elas-
ticity of demand for imports is a crucial determinant of the response of the trade balance to movements in the
exchange rate. A classical question is whether depreciation of a nation's currency improve its trade balance |
a question that is of particular interest in a world with incomplete nancial markets and lies at the core of the
external adjustment and the cross-border transmission of ination.
20
iun. 1hoso oxpiossions can Lo usoo in spocifying ompiiical iogiossion moools which aio consislonl
wilh alloinaliyo lhooiolical yiows of pass-lhiough. Moiooyoi. wo will uso oui ouanlilaliyo moool
lo sluoy lho poifoimanco of alloinaliyo iogiossion moools lypically aooploo in ompiiical sluoios
which. Locauso of oala ayailaLilily. cannol confoim lo oui sliucluial ooualions. Wo will
lhoiofoio Lo aLlo lo iun oxamplos pioyioing a ouanlilaliyo assossmonl of lho Lias.
Il is woilh sliossing lhal lho pioLloms of omilloo yaiiaLlos ano moasuiomonl oiiois aio
likoly lo plaguo yiilually all applioo papois liying lo oslimalo sliucluial LII1. 1ho accuiacy
of pass-lhiough oslimalos is lhoiofoio a ciucial issuo foi lho ompiiical liloialuio. Lul has also an
impoilanl policy oimonsion. 1hoso oslimalos aio coio inpuls inlo lho piojoclions of oxchango
ialo changos onlo piicos ano oulpul which unooilio monolaiy policy oocision making.
5.1 Inspecting the mechanism(s): structural ERPT equations
5.1.1 ERPT and price discrimination
Lol us consiooi lisl oui spocilcalions wilh loxiLlo piicos. 1ho log-linoai oxpiossion foi lho piico
of impoils is:
´
1
f.t
=
1
1 ÷j(:/
f
÷1)

´
c
t
÷
[
'C

f.t

÷
j(:/
f
÷1)
1 ÷j(:/
f
÷1)
¯
'C
n.t
(18)
whoio :/
f
is lho sloaoy slalo maikup ano j is lho oisliiLulion maigin in lho homo impoil
socloi. As long as j is sliiclly aLoyo zoio. lho coomcionl on lho oxchango ialo will Lo loss lhan
ono. ano so will Lo LII1.
In oui Lonchmaik caliLialion. plausiLlo maikups ano sliucluial paiamoloi yaluos imply lhal
lho LII1 coomcionl is ooual lo 0.08. Locauso of lho piosonco of oisliiLulion soiyicos. lho impacl
of changos in lho nominal oxchango ialo on lho piicos lhal consumois pay foi impoil will Lo
lowoi:
´
1
f.t
= (1 ÷j)
´
1
f.t
÷j
´
1
n.t
Wilh a oisliiLulion maigin as high as ò0 poiconl. pass-lhiough lo consumoi piicos (of impoils)
falls lo 46 poiconl. As noloo Ly lho liloialuio. lho implicalions of oisliiLuliyo liaoo foi local
cuiioncy piico slaLilily is ouilo iomaikaLlo oyon in moools wilh loxiLlo piicos ano wagos.
21
5.1.2 ERPT and local currency price stickiness
In oui moool. wo hayo assumoo a ouaoialic piico-aojuslmonl cosl foi Foioign oxpoil piicos
in Homo cuiioncy. in lho foim
i
j
F
2

1
f,t
(1)
1
f,t1
(1)
÷¬

2
1
f,t
1

f,t
. Solying foi oplimal piicing.
imposing symmoliy ano log-linoaiizing aiouno a sloaoy slalo . wo oLlain:
´
1
f.t
=

´
c
t
÷
[
'C

f.t

1 ÷j(:/
f
÷1) ÷i
j
F
¬
2
(:/
f
÷1) (1 ÷)
÷
j(:/
f
÷1)
1 ÷j(:/
f
÷1) ÷i
j
F
¬
2
(:/
f
÷1) (1 ÷)
´
1
n.t
÷
i
j
F
¬
2
(:/
h
÷1)
1 ÷j(:/
f
÷1) ÷i
j
F
¬
2
(:/
f
÷1) (1 ÷)

1
t
´
1
f.t+1
÷
´
1
f.t1

.
whoioas lho nominal maiginal cosl 'C

f.t
=
(\

t
)
c
(1

t
)
1c
7
f,t
. ano as Lofoio :/
f
oonolos lho
lolal maikup (incluoing Lolh oisliiLulion ano slanoaio maikup) in lho impoiloo Homo liaoaLlo
socloi.
1ho aLoyo ooualion highlighls lho lwo mochanisms of impoifocl pass-lhiough omLooooo in
oui analysis. In lho shoil iun. oyon if piicos aio fully loxiLlo coiiosponoing lo i
j
F
= 0 lho
pass-lhiough coomcionl is loss lhan 1 poi olocl of oisliiLuliyo liaoo. coiiosponoing lo j 0.
Whon lhoio aio no oisliiLulion cosls (j = 0). lho shoil-iun pass-lhiough coomcionl is loss lhan
1 only whon lhoio aio nominal iigioilios.
1ho low pass-lhiough coomcionl in lho shoil iun moslly iolocls nominal piico iigioilios.
CaliLialing lho moool accoioing lo lho oyioonco in Lils ano Klonow [2004[. foi an ayoiago
nominal piico iigioilios of 4.8 monlhs. lho shoil iun coomcionl luins oul lo Lo 0.27. In luin.
assuming lhal piicos aio. on ayoiago. lxoo foi lhioo ouailois lowois lhis yaluo lo 4 poiconl. In
lho long iun. nominal iigioilios aio oLyiously iiioloyanl. ano impoifocl pass-lhiough can only
Lo alliiLuloo lo lho implicalions of oisliiLulion foi lho piico olaslicily of impoils. Doponoing
on lho oogioo of monopolislic oisloilions. in oui moool lho long-iun LII1 is 08 poiconl. Iocall
lhal wilh a oisliiLulion maigin of ò0 poiconl. pass-lhiough onlo consumoi piicos will Lo half
22
lho oogioo of pass-lhiough onlo piicos al lho oock. namoly:
´
1
f.t
= (1 ÷j)
´
1
f.t
÷j
´
1
n.t
= (1 ÷j)

´
c
t
÷
[
'C

f.t

1 ÷j(:/
f
÷1) ÷i
j
F
¬
2
(:/
f
÷1) (1 ÷)
÷
(1 ÷j)
i
j
F
¬
2
(:/
h
÷1)
1 ÷j(:/
f
÷1) ÷i
j
F
¬
2
(:/
f
÷1) (1 ÷)

1
t
´
1
f.t+1
÷
´
1
f.t1

÷
(1 ÷j)
j(:/
f
÷1)
1 ÷j(:/
f
÷1) ÷i
j
F
¬
2
(:/
f
÷1) (1 ÷)
´
1
n.t
÷j
´
1
n.t
.
OLsoiyo lhal lho log linoai ooualion foi lho oomoslic piicos aLioao is:
´
1

f.t
=
[
'C

f.t
1 ÷j(:/

f
÷1) ÷i
j
F
¬
2
(:/

f
÷1) (1 ÷)
÷
j(:/

f
÷1)
1 ÷j(:/

f
÷1) ÷i
j
F
¬
2
(:/

f
÷1) (1 ÷)
´
1

n.t
÷
i
j
F
¬
2
(:/

f
÷1)
1 ÷j(:/

f
÷1) ÷i
j
F
¬
2
(:/

f
÷1) (1 ÷)

1
t
´
1

f.t+1
÷
´
1

f.t1

.
ComLining ooualions (assuming symmoliy) wo oLlain a sliucluial ooualion of lho ooloiminanl
of ooyialions fiom lho law of ono piico al wholosalo (Loiooi) loyol:
´
c
t
÷
´
1

f.t
÷
´
1
f.t
=

j(:/
f
÷1) ÷ (:/
f
÷1) i
j
F
¬
2
(1 ÷)
1 ÷j(:/
f
÷1) ÷i
j
F
¬
2
(:/
f
÷1) (1 ÷)

´
c
t
÷
(:/
f
÷1) j
1 ÷j(:/
f
÷1) ÷i
j
F
¬
2
(:/
f
÷1) (1 ÷)

´
1

n.t
÷
´
1
n.t

÷
(:/
f
÷1) i
j
F
¬
2
1 ÷j(:/
f
÷1) ÷i
j
F
¬
2
(:/
f
÷1) (1 ÷)
¸
1
t
´
1

f.t+1
÷
´
1

f.t1

÷

1
t
´
1
f.t+1
÷
´
1
f.t1

As poinloo oul Ly Coisolli ano Dooola [200ò[. lhoso ooyialions aio a funclion of lho oogioo of
monopolislic oisloilions (maikup). as woll as lho piico of nonliaooo gooos ano soiyicos omployoo
in oisliiLulion (foi j 0). Oui oynamic analysis also poinl oul a iolo foi inlalion ano piico
aojuslmonl cosls.
5.1.3 Regression bias and endogenous exchange rate volatility
Whon Liinging lho moool lo lho oala. oui analysis makos il cloai lhal an ompiiically consislonl
spocilcalion of lho iogiossion moool woulo call foi lho inclusion nol only of maiginal cosls in
lho liaoaLlo socloi. Lul also of maiginal cosls oi piicos in lho oisliiLulion socloi (which in oui
28
analysis aio lho samo as nonliaoaLlo gooos) lo accounl foi lho olocl of oisliiLuliyo liaoo on
lho piico olaslicily ano maikup . as woll as foi lho oxpocloo yaluo of 1
t
´
1
f.t+1
lo accounl
foi lho oynamic oimonsion of oplimal piicing wilh foiwaio-looking piico sollois. Wo shoulo
slioss hoio lhal lho omission of lho lalloi yaiiaLlo is Louno lo iosull inlo omilloo-yaiiaLlo Lias.
1ho log-linoaiizoo oxpiossions ooiiyoo aLoyo is alioaoy usoful lo shoo lighl inlo lho conso-
ouoncos of using incomplolo oala sols. oi yaiiaLlos moasuioo wilh laigo oiioi. Foi simplicily.
assumo lhal lho coiiocl moool is lho ono wilhoul nominal iigioilios ano consiooi a iogiossion
moool in lho foim
1
f.t
=
1
c
t
÷
2
A
t
÷·
t
whoioas lo sayo on nolalion wo ignoio lho facl lhal all yaiiaLlos shoulo Lo moasuioo in logs.
Hoio A
t
iofois lo a sol of conliol yaiiaLlos (o.g. oomoslic GDI) which aio impoifocl pioxios of
lho ioloyanl yaiiaLlos lisloo aLoyo. Cloaily. using oui oxpiossions. wo can wiilo lho oiioi as:
·
t
=
1
1 ÷j(:/
f
÷1)
'C

f.t
÷
j(:/
f
÷1)
1 ÷j(:/
f
÷1)
'C
n.t
÷
2
A
t
÷:
t
whoio : is any uncoiiolaloo ianoom compononl (o.g.. moasuiomonl oiioi). Wo oLlain lho
following asymplolic oslimalo of
1
:
´

1
=
1
1 ÷j(:/
f
÷1)
÷/ia:.
/ia: =

1
\ ar (c
t
) ÷
Co· (c
t
. A
t
)
\ ar (A
t
)

Co·

c
t
.
1
1 ÷j(:/
f
÷1)
'C

f.t
÷
j(:/
f
÷1)
1 ÷j(:/
f
÷1)
'C
n.t

÷Co· (c
t
. A
t
)
Co·

A
t
.
1
1+j(nIf1)
'C

f.t
÷
j(nIf1)
1+j(nIf1)
'C
n.t

\ ar (A
t
)

1ho Lias can hayo oilhoi sign. 1o soo lhis mosl cloaily. consiooi lhal. in gonoial. lho ayailaLlo
conliol A
t
will Lo a yoiy pooi insliumonl foi lho omilloo yaiiaLlo 'C
n.t
. Focus on lho oxliomo
caso in which A
t
is missing allogolhoi fiom lho iogiossion moool. Omilling A
t
lho aLoyo Lias
simplilos lo:
/ia: =
Co·

c
t
.
1
1+j(nIf1)
'C

f.t
÷
j(nIf1)
1+j(nIf1)
'C
n.t

\ ar (c
t
)
24
1ho iogiossion Lias cloaily ooponos on lho coyaiianco Lolwoon c
t
ano lho piooucliyily shocks
7
f,t
ano 7
n,t
alocling maiginal cosls in lho lwo oconomios. Whon maiginal cosls aio Lasically
uncoiiolaloo acioss Loiooi (lho caso of counliy-ioiosyncialic shocks). lho sign of lho Lias will
oopono on lho inloinalional liansmission` of piooucliyily shocks. If (ooponoing on paiamolois`
yaluo) a posiliyo Homo shock appiocialos lho Homo nominal oxchango ialo. lho iogiossion Lias
will Lo positive: pass-lhiough oslimalos will Lo higher lhan lho liuo coomcionl
1
1+j(nIf1)
. If
insloao a posiliyo Homo piooucliyily shock Liings aLoul a nominal oopiocialion. lho opposilo
will occui. In lhooiy. Lolh olocls can occui (soo Coisolli. Dooola ano Loouc [2004[).
Lul whilo lho sign of lho Lias ooponos on lho palloin of coyaiiancos. lho sizo of lho Lias
will Lo ciucially alocloo Ly lho yolalilily of lho oxchango ialo (iolaliyo lo lho coyaiianco of lho
oxchango ialo wilh lho conliol). 1his suggosls lhal. ceteris paribus. an oconomy wilh a highly
yolalilo oxchango ialo woulo pioyioo a iolaliyoly Lolloi onyiionmonl foi ompiiical analysis.
5.2 Regression bias in empirical models of ERPT: an assessment using sim-
ulated time series
Lmpiiical iosoaich on LII1 focusos on lho aojuslmonl of piicos lo an oxchango ialo chango
foi liansaclions Lolwoon an oxpoiling ano impoiling counliy. Accoioing lo lho laxonomy in
GoloLoig ano Knolloi (1007). lho lypical LII1 iogiossion can Lo wiillon as
{
t
= c ÷c
t
÷(
t
÷cA
t
÷n
t
. (10)
whoio all yaiiaLlos aio in logs: {
t
is lho impoil piico oonominaloo in local cuiioncy. (
t
is a
moasuio of oxpoiloi`s maiginal cosls. A
t
may incluoo conliols foi shifls in impoil oomano (liko
piicos of compoling gooos oi incomo in lho impoiling counliy). as woll as laggoo yaluos of
lho ooponoonl yaiiaLlo lo capluio oynamics. ano c
t
is lho nominal oxchango ialo (impoiloi`s
cuiioncy poi unil of oxpoiloi`s cuiioncy). 1ho coomcionl is iofoiioo lo as lho pass-lhiough
coomcionl. LII1 conoilional on conliols A
t
ano (
t
is full oi complolo if = 1 ano is
incomplolo if < 1. Iioyiooo ono can lno an accuialo moasuio of maiginal cosl (
t
. lho coomcionl
moasuios lho yaiiaLlo maikup compononl of lho loxlLook oolnilion of pass-lhiough.
1ho lypical pass-lhiough iogiossion lioals maiginal cosls as oiioclly oLsoiyaLlo. Lul incluoos
cosl inoicos. 1hoso inoicos may Lo ioasonaLlo moasuios of ayoiago cosls incuiioo oomoslically.
Lul aio unlikoly lo Lo gooo moasuios of maiginal cosls. which is lho ioloyanl concopl in spoc-

ifying oplimal piicing Ly pioll-maximizing lims. Fuilhoimoio. moasuiomonl oiiois in cosl
inoicos may Lo coiiolaloo wilh oxchango ialos in ways lhal Lias lho coomcionls lowaio lnoing
incomplolo pass-lhiough ano oxcoss maikup aojuslmonl.
1ho iosoaich on piicing-lo-maikol (honcofoilh I1M) has aooiossoo lhis issuo incluoing piicos
in Lolh lho oiigin ano lho ooslinalion maikols. as woll as cosls. in lho ompiiical iogiossions.
In loims of (10). {
t
is lho oxpoil piico. (
t
is lho oomoslic piico of lho samo gooo. whilo A
t
incluoos olhoi cosl faclois ano oomano shiflois in Lolh maikols. Cosls. ano lhus oiiois in cosls.
inluonco lho oxpoil piico iolaliyo lo lho oomoslic piico only whon lhoio is a oiloionco in lho
conyoxily of oomano in lho lwo maikols (o.g.. soo Maislon [1000[).
15
1o shoo lighl on lho ouanlilaliyo impoilanco of oiloionl polonlial souicos of Liasos in lho
ompiiical sluoios of pass-lhiough. wo iun lwo lypos of iogiossions on lho aililcial oala simulaloo
using oui lhooiolical oconomios. Wo ouL lho lisl ono LII1 iogiossion`:
1
f.t
= c ÷c
t
÷\

t
÷c
1
1
t
÷c
2
1
f.t1
. (20)
In loims of (10). lho LII1 iogiossion incluoos Foioign nominal wagos. \

t
. lo conliol foi mai-
ginal cosls in lho oxpoiling counliy. ano Homo ioal GDI. 1
t
. lo conliol foi oomano conoilions in
lho impoiling counliy. Wo also incluoo ono lag of lho ooponoonl yaiiaLlo lo capluio oiloioncos
Lolwoon shoil iun ano long iun pass-lhiough lhal aio ioloyanl in lho oconomios wilh nominal
iigioilios. 1hus. lho oxchango-ialo coomcionl iopiosonls lho oslimalo of lho shoil-iun LII1
coomcionl. whilo

1 ÷c
2
will Lo lho oslimalo of lho long-iun LII1 coomcionl.
1ho socono iogiossion. which wo ouL lho I1M iogiossion`. has lho following spocilcalion:
1
f.t
= c ÷c
t
÷1

f.t
÷c
1
1
h.t
÷c
2
1
f.t1
. (21)
In lino wilh lho insighls fiom lho I1M liloialuio. lhis iogiossion incluoos lho oomoslic piico
of Foioign oxpoils. 1

f.t
. lo conliol foi maiginal cosl in lho oxpoiling counliy. ano lho Homo
III of liaoaLlos. 1
h.t
. lo conliol foi oomano conoilions in lho impoiling counliy. As aLoyo. wo
also incluoo lho laggoo ooponoonl yaiiaLlo. so lhal iopiosonls lho shoil-iun LII1 coomcionl.
15
Most studies of PTM use international price data which do not reveal the invoice currency. For instance,
since he compared Japanese export and domestic prices, Marston (1990) had to allow for possible eects of foreign
currency invoicing, distinguishing between short run and long run PTM. Although sticky prices in the foreign
currency contribute to PTM in the short run, for Japanese exports Marston (1990) nds that substantial PTM
persists beyond the period in which prices are sticky.
26
whilo

1 ÷c
2
will Lo oui oslimalo of lho long-iun LII1 coomcionl. Moiooyoi. in lino wilh lho
I1M liloialuio wo imposo lho consliainls: = (o.g.. soo Anooilon [2008[).
Lolh iogiossions aio cloaily misspociloo in lho conloxl of oui lhooiolical moools. as lhoy
oo nol conliol foi lho olocl of lho cosl of oisliiLulion on oomano olaslicilios. ano suloi fiom
moasuiomonl oiioi pioLloms. as lhoy ioly on pioxios of lho gonoially unoLsoiyaLlo maiginal
cosls. Iiocisoly. (20) only incluoos nominal wagos. Lul omil lho piico of capilal ano moasuios
of lochnology shocks. Ly lho samo lokon. lho inclusion of lho Foioign piico of Homo impoils
among lho iogiossois in (21) is a polonlial souico of Lias. as lhis piico incluoos a Foioign maikol
limo-yaiying maikup.
16
1aLlos 4A lhiough òL piosonl lho iosulls of lho I1M iogiossion ano lho LII1 iogiossion
iun on oui simulaloo limo soiios. 1ho oslimaloo coomcionls in lhoso laLlos aio compuloo using
lho samo ò000 oLsoiyalion usoo lo calculalo lho Lusinoss-cyclo slalislics. Foi oach lhooiolical
oconomy. lho laLlo shows lho liuo yaluo of lho shoil iun ano long iun coomcionls ano

1 ÷c
2
in
lho lwo iows unooi lho hoaoing Structural. As shown aLoyo. lhoso coomcionls iolocl lho yaluo of
lho sliucluial paiamolois in lho log-linoaiizoo lisl oiooi conoilions of lho monopolislic Foioign
oxpoiloi. 1hus. lho shoil-iun ano long-iun coomcionls coincioo in lho Lonchmaik moool wilh
loxiLlo piicos. ano lhoii loyol. ooual lo 0.08. is fully ooloiminoo Ly lho sloaoy slalo loyol of lho
maikup in lho impoil socloi. :/
h
. ano lho oisliiLulion maigin. j. Conyoisoly. lho shoil-iun
ano long-iun coomcionls oiloi in lho slicky piico moool. Locauso of lho ooslinalion-spocilc
piico aojuslmonl cosl. lho shoil iun coomcionl is ooual lo oilhoi 0.27 oi 0.04 ooponoing on lho
oogioo of piico slickinoss. whilo lho long iun coomcionl is 0.08. as in lho Lonchmaik. NolaLly.
lho yaluos foi lho shoil-iun coomcionls aio woll in lho iango of lho oslimalos foi lho U.S. ano
in gonoial lho inousliializoo counliios (o.g.. soo Anooilon [2008[ foi lho ouio aioa ano Campa
ano GoloLoig [2002[ foi a laigo sol of OLCD counliios. iospocliyoly).
1ho laLlos also iopoil a conliol iogiossion in which lho impoil piico is iogiossoo only on
lho oxchango ialo ano ils lag wo ouL lhis spocilcalion naiyo". 1his spocilcalion cloaily
shows lhal lho pioLlom of omilloo yaiiaLlos can polonlially Lo yoiy soiious in oui solup wilh
16
Interestingly, however, the restrictions on coecients embedded in this specication are true in our model of
price discrimination driven by distribution costs, provided one includes the true structural variables Xt and Zt in
the regression, that is, the Foreign marginal cost in the tradable sector and the price of distribution in the Home
country.
27
an onoogonously yolalilo oxchango ialo. Inoooo. lho oslimaloo shoil iun LII1 is always loss
lhan 1 poiconl acioss all spocilcalions. oyon wilh loxiLlo piicos. whilo lho long iun oslimalos
aio ioasonaLly closo lo lho sliucluial coomcionl only in lho caso of high piico slickinoss. 1his
iosull conlims lhal lhoso oconomios can Lo lhoughl of as an inloiosling woisl caso" sconaiio
foi assossing lho poifoimanco of somo populai iogiossion moools in lho ompiiical liloialuio on
pass-lhiough.
In lighl of lho aLoyo iosulls. ooos lho inclusion of conliols. alLoil impoifocl. impioyo lho
poifoimanco of lho iogiossion moools´ Inloioslingly. wo lno lhal in gonoial il ooos so. Focus
al lisl on 1aLlos 4A ano 4L. In lhoso laLlos. a nolaLlo oiloionco acioss lho lwo spocilcalions
(lho I1M ano LII1 (1)) omoigos only in lho caso of loxiLlo piicos. 1ho I1M iogiossion
ooos pailiculaily woll al oislinguishing Lolwoon shoil- ano long-iun coomcionls whon lhoy aio
liuly oiloionl. ano coiioclly ooualos lhoii oslimalos whon lhoy aio lho samo (in lho caso of
lho oconomy wilh loxiLlo piicos). In conliasl. lho LII1 spocilcalion incoiioclly oslimalos a
oiloionl yaluo of lho shoil- ano long-iun coomcionls whon piicos aio loxiLlo. Wilh slicky piicos.
lho I1M iogiossion in 1aLlo 4A Lasically iocoyois lho coiiocl yaluo of lho long-iun sliucluial
coomcionl. Lul oisplays an upwaio Lias in lho oslimalos of lho shoil iun coomcionl. In conliasl.
lho oslimaloo long-iun coomcionl fiom lho LII1 iogiossion show a small upwaio Lias. whilo
lho shoil-iun coomcionl is closoi lo lho sliucluial ono lhan in lho caso of lho I1M iogiossion.
Similai iosulls omoigo fiom laLlo 4L. allhough lho sizo of lho Lias hoio is laigoi.
Whal can accounl foi lho oiloionlial poifoimanco of lho lwo iogiossions´ In oiooi lo answoi
lhis ouoslion wo also iopoil iosulls foi an hyLiio spocilcalion (LII1 (2)). ooual lo lho LII1
spocilcalion. oxcopl lhal wo ioplaco lho oomoslic GDI wilh 1
h.t
in 1aLlo 4A ano wagos wilh
1

f.t
in 1aLlo 4L. In oui oxpoiimonls. lho hyLiio spocilcalion LII1 (2) ooos Lolloi lhan lho
LII1 spocilcalion. suggosling lhal lho oyoiall supoiioi poifoimanco of lho I1M iogiossion
can Lo liacoo lo lho uso of Lolloi pioxios foi maiginal cosls ano oomano conoilions. Wo nolo
lhal. giyon lhal lho gonoial onyiionmonl of oui moool incluoos piico oisciiminalion. lho pioxios
aooploo in LII1 (2) hayo a gooo lhooiolical founoalions. Il is somohow ioassuiing lhal lhoii
uso impioyos lho poifoimanco of oui iogiossions.
1aLlos òA ano òL iopoil iosulls foi lho moool wilh slicky piicos conoilional on monolaiy
shocks only. 1ho shocks aio apponooo lo lho inloiosl-ialo iulos ano aio assumoo lo hayo a
slanoaio ooyialion ooual lo 0.2 poiconl ano lo Lo uncoiiolaloo acioss counliios. 1ho moliyalion
28
foi lhis oxoiciso is lo assoss lho sonsiliyily of oui iosulls lo oiloionl shocks. Iolaliyo lo laLlo
4. lho poifoimanco of lho I1M iogiossion moool ooloiioialos maikooly. In pailiculai. wilh
monolaiy shock only. lho iolaliyo oualily of lho iogiossion poifoimanco is ioyoisoo.
Ono possiLlo ioason foi lho ioyoiso ianking in lho poifoimanco of lho I1M ano LII1
iogiossions is lhal. wilh monolaiy shocks only. lho nominal wago (which is loxiLlo in oui moool)
is a Lolloi pioxy foi maiginal cosls lhan piooucl piicos. whoso aojuslmonls aio consliainoo Ly
nominal iigioilios. In lho aLsonco of fiiclions in lho laLoi maikol. oouiliLiium nominal wagos
follows closoly lho monolaiy slanco in lho oconomy. Howoyoi. in lho caso of low piico iigioily.
ono woulo oxpocl piicos lo iolocl maiginal cosls ano wagos ouilo a Lil. Inoooo. lho laLlo shows
lhal a hyLiio I1M iogiossion moool (ouLLoo I1M (2). incluoing lho loyol of oomoslic oulpul
in lho placo of oomoslic piicos). lonos lo poifoim ouilo woll. 1his iosull suggosls lhal lho
oiloionco in lho poifoimanco of lho I1M ano lho LII1 moool in 1aLlo ò is ouo lo lho pioxy
foi lho loyol of oomoslic oomano.
Oyoiall. oui oxpoiimonls in 1aLlo ò inoicalo lhal lho oualily of ayailaLlo ompiiical pioxios
foi maiginal cosls ano oomano (ooloimining lho poifoimanco of oiloionl ompiiical moools)
will lypically oopono on lho lypo of oisluiLancos alocling lho oconomy. 1hus. assossing lho
sonsiliyily of pass-lhiough oslimalos lo lho inclusion of alloinaliyo pioxios foi maiginal cosls
ano impoil oomano is ciucial foi lho ioliaLilily of lhoso oslimalos.
17
17
What conclusions can be drawn from estimating ERPT coecients? Even if econometricians were able to
recover precise estimates of structural pass-through coecients, there will still be a question about their use in
policy-oriented exercises addressing the impact of specic shocks on import prices or, more in general, on the
CPI. The main issue is that, in general, structural pass-through coecients are not a complete description of the
actual properties of the model as regards the link between import prices and exchange rates. In each particular
period, this link will be determined conditional on the specic shocks causing exchange rate uctuations. To
clarify this point: in all our specications import prices responds one-to-one to monetary shocks in the long run
(in the benchmark economy where prices are exible this is so also in the short run). Hence, conditional on
monetary disturbances, long-run ERPT is perfect. Even if the long-run exchange rate coecient in the pass-
through equation is lower than one, perfect pass-through from monetary shocks will eventually results because
such disturbances will bring about related movements in the other endogenous variables entering the structural
equation that determines the price of imports | hence running against the `ceteris paribus' assumption implicit
in interpreting the ERPT coecient in the structural regressions. Specically, a monetary easing in the Home
country that depreciates the Home currency will eventually cause a proportional increase in the nominal price of
distribution services. Putting all these elements together, it is easy to verify that import prices will eventually
rise one-to-one with the exchange rate. The lesson is that using structural equations to forecast the impact of
20
6 Concluding remarks
Unooislanoing lho iolaliyo impoilanco of oiloionl faclois causing high oxchango ialo yolalilily.
on lho ono hano. ano low pass-lhiough ano local cuiioncy piico slaLilily. on lho olhoi. is ciucial
foi Lolh moool Luiloing ano policy analysis. As is woll known. a coio implicalion of low pass-
lhiough is lhal high oxchango-ialo yolalilily will syslomalically oiiyo apail cioss-Loioois piicos
of olhoiwiso ioonlical gooos i.o. lhoio will Lo ooyialions fiom lho law of ono piico. In
lho aLsonco of nominal iigioilios. such ooyialions coiiospono lo oplimal piicing slialogios Ly
lims wilh monopoly powoi. In lho piosonco of nominal iigioilios. insloao. lhoy coiiospono lo
suLoplimal luclualions of lims` piolls. wilh polonlially impoilanl consoouoncos foi lho oosign
of slaLilizalion policy iulos. Moiooyoi. in an oconomy wilh laigo swings in lho oxchango ialo. lack
of iisk shaiing oppoilunilios imply laigo luclualions of iolaliyo woallh ano consumplion. 1hoso
consiooialions iaiso lho ouoslion of wholhoi oxchango-ialo moyomonls play lho slaLilizing iolo
alliiLuloo lo lhom Ly lho iocoiyoo wisoom. oilhoi as a suLslilulo foi iolaliyo piico aojuslmonl
oi as mochanism iooucing lho consumplion iisk of piooucliyily ano nominal shocks.
1his papoi ooyolops a ouanlilaliyo. oynamic. opon-oconomy fiamowoik which gonoialos
high oxchango ialo yolalilily. ano analyzos lho iolo of nominal iigioilios (in lho foim of local
cuiioncy piicing) in ooloimining a low oogioo of LII1. Locauso of lho piosonco of oisliiLulion
soiyicos. lho olaslicily of oomano is maikol spocilc. which loaos lims lo piico-oisciiminalo acioss
counliios. In oui moool. lho comLinalion of piico oisciiminalion ano local cuiioncy piicing wilh
nominal iigioily can accounl foi lho yaiiaLlo oogioo of LII1 oyoi oiloionl hoiizons. As a
iosull of piico oisciiminalion. oui moool piooicls oxchango-ialo pass-lhiough coomcionls lhal
aio oiloionl lhan ono in lho long iun. In lho shoil iun. wo lno lhal a yoiy small amounl of
nominal iigioilios can lowoi lho olaslicily of impoil piicos al Loiooi ano consumoi loyol lo 27/
ano 18/. iospocliyoly.
Wo slioss lhal in oui Lonchmaik oconomy a limiloo oogioo of LCI makos lho shoil-iun
oxchango ialo pass-lhiough coomcionls ouilo closo lo lhoso founo in lho ompiiical liloialuio:
foi inslanco Campa ano GoloLoig [2002[ lno lhal on ayoiago acioss OLCD counliios. oxchango
ialo pass-lhiough inlo impoil piicos is 46/ in lho shoil iun ano oyon lowoi foi lho US. Iolaliyo
exchange rate movements on prices can be severely misleading if one fails to control for the general equilibrium
eects of the shocks hitting the economy.
80
lo lhoso ompiiical iosulls. oui iosulls suggosl lhal an amounl of nominal iigioilios consislonl
wilh lho oyioonco in Lils ano Klonow [2004[) will Lo onough lo mako oui lhooiolical oconomios
consislonl wilh lhis oimonsion of lho oala.
IomaikaLly. in oui moool. oospilo lho low loyol of pass-lhiough. oxchango ialo oopiocialion
slill woisons lho loims of liaoo in accoio lo lho oyioonco. Moiooyoi. a high oogioos of nominal
iigioilios aio nol nocossaiy lo gonoialo yolalilo oxchango ialos.
Iogiossion moools commonly usoo in lho ompiiical liloialuio on oxchango ialo pass-lhiough
aio likoly lo Lo plaguoo Ly moasuiomonl oiiois ano omilloo yaiiaLlo Lias. Wo iun lwo lypical
iogiossion moools on limo soiios gonoialoo Ly oui moool. ano compaio lhoii poifoimanco wilh
lho sliucluial foaluios of lho moool. In mosl casos. lho iogiossions yiolooo poinl oslimalos
lhal woio Liasoo. Lul slill ioasonaLlo. Oui iosulls show lhal. in gonoial. a high oxchango ialo
yolalilily will nol Lo sumcionl lo alloyialo lho Lias ouo lo onoogonoily of such yolalilily.
1ho poifoimanco of lho iogiossion moools cloaily ooponos on how woll lho iogiossois pioxy foi
maiginal cosls ano oomano conoilions. Wo illuslialoo lhis poinl Ly showing lhal conoilioning on
a oiloionl sol of shocks (ioal yoisus nominal) coulo chango lho oualily of lhoso pioxios. causing
a ioyoisal in lho ianking of alloinaliyo iogiossion moools. 1hus. assossing lho sonsiliyily of pass-
lhiough oslimalos lo lho inclusion of alloinaliyo pioxios foi maiginal cosls ano impoil oomano
is ciucial foi lho ioliaLilily of lhoso oslimalos.
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Table 1. Parameter values
Benchmark Models
Iiofoioncos ano 1ochnology
Iisk ayoision o = 2. ò
Disulilily of laLoi c = 1.18
Volocily paiamoloi . = 0.1
Llaslicily of suLslilulion Lolwoon:
Homo ano Foioign liaooo gooos
1
1a
= 0.ò. 1.ò
liaooo ano non-liaooo gooos
1
1c
= 0.74
Homo non-liaooo gooos 0
N
= 7.7
Homo liaooo gooos 0
H
= 1ò.8
Llaslicily of lho oiscounl facloi
wilh iospocl lo C ano 1 c = 0.006
DisliiLulion maigin j = 0.ò (: = 1.22)
LaLoi shaio in liaoaLlos : = 0.61
LaLoi shaio in nonliaoaLlos c = 0.ò6
Dopiocialion ialo c = 0.02ò
Monolaiy Iolicy
Laggoo inloiosl-ialo coomcionl j = 0.84
Woighl on inlalion . = 2.10
Woighl on oulpul gap = 0.8
Socloial piooucliyily shocks
Socloial aulocoiiolalion maliix ` =

0.0ò 0.0
0.0 0.0ò
¸
¸
¸
Socloial yaiianco-coyaiianco maliix (in poiconl) \ =

0.7 0.00128
0.00128 0.7
¸
¸
¸
86
Table 2A. Exchange rates and prices in the theoretical economies
o
U.S. Dala Economy with o = 2. . = 0.ò
Slalislics FloxiLlo piicos
Slicky piicos
low 1C1
Slicky piicos
high 1C1
Standard deviation (relative to GDP)
Ioal oxchango ialo (CII Lasoo) 8.04 8.86 4.12 7.87
Nominal oxchango ialo 8.26 4.40 ò.17 8.68
1oims of liaoo 1.71 2.08 8.20 6.80
Impoils 8.28 2.88 2.20 2.41
Auto-correlation
Ioal oxchango ialo 0.81 0.72 0.70 0.87
GDI 0.87 0.78 0.74 0.72
Correlation with real exchange rate
Nominal oxchango ialo 0.06 0.02 0.0ò 0.08
1oims of liaoo 0.8ò 0.82 0.80 -0.48
Cioss-counliy consumplion ialio -0.4ò -0.66 -0.77 -0.88
Correlation with nominal exchange rate
Impoil piicos 0.4ò 0.01 0.88 0.60
CII loyol -0.17 0.42 0.40 0.80
Dierence between cross-correlation of
GDI ano consumplion 0.22 0.88 0.40 0.ò6
Correlation with GDP
Nol oxpoils -0.ò1 -0.48 -0.86 -0.27
o
Soo main loxl foi a oosciiplion of lho oiloionl moool oconomios.
87
Table 2B. Exchange rates and prices in the theoretical economies
o
U.S. Dala Economy with o = ò. . = 1.ò
Slalislics FloxiLlo piicos
Slicky piicos
low 1C1
Slicky piicos
high 1C1
Standard deviation (relative to GDP)
Ioal oxchango ialo (CII Lasoo) 8.04 8.40 8.ò8 8.72
Nominal oxchango ialo 8.26 8.00 2.81 8.22
1oims of liaoo 1.71 2.68 2.84 2.20
Impoils 8.28 2.8ò 1.02 1.41
Auto-correlation
Ioal oxchango ialo 0.81 0.71 0.76 0.82
GDI 0.87 0.71 0.72 0.81
Correlation with real exchange rate
Nominal oxchango ialo 0.06 0.62 0.68 0.6ò
1oims of liaoo 0.8ò 0.ò4 0.88 -0.10
Cioss-counliy consumplion ialio -0.4ò 1.00 1.00 1.00
Correlation with nominal exchange rate
Impoil piicos 0.4ò 0.ò8 0.ò8 0.4ò
CII loyol -0.17 0.1ò 0.1ò 0.10
Dierence between cross-correlation of
GDI ano Consumplion 0.22 -0.8ò -0.26 -0.18
Correlation with GDP
Nol oxpoils -0.ò1 0.66 0.68 0.ò7
88
Table 3A. Exchange rates and prices in the theoretical economies, under
alternative monetary policies
o
U.S. Dala
Economy with :
o = 2. . = 0.ò. low LCP
Slalislics Lonchmaik k-poiconl iulo Inlalion-laigoling
Standard deviation (relative to GDP)
Ioal oxchango ialo (CII Lasoo) 8.04 4.12 4.00 8.72
Nominal oxchango ialo 8.26 ò.17 4.ò1 8.72
1oims of liaoo 1.71 8.20 8.10 2.88
Impoils 8.28 2.20 2.26 2.20
Auto-correlation
Ioal oxchango ialo 0.81 0.70 0.74 0.71
GDI 0.87 0.74 0.77 0.74
Correlation with real exchange rate
Nominal oxchango ialo 0.06 0.0ò 0.00 1.00
1oims of liaoo 0.8ò 0.80 0.44 0.46
Cioss-counliy consumplion ialio -0.4ò -0.77 -0.76 -0.76
Correlation with nominal exchange rate
Impoil piicos 0.4ò 0.88 0.88 0.86
CII loyol -0.17 0.40 0.48 -0.2ò
Dierence between cross-correlation of
GDI ano consumplion 0.22 0.40 0.41 0.40
Correlation with GDP
Nol oxpoils -0.ò1 -0.86 -0.8ò -0.80
o
Soo main loxl foi a oosciiplion of lho oiloionl moool oconomios.
80
Table 3B. Exchange rates and prices in the theoretical economies
o
U.S. Dala
Economy with :
o = ò. . = 1.ò. low LCP
Slalislics Lonchmaik k-poiconl iulo Inlalion laigoling
Standard deviation (relative to GDP)
Ioal oxchango ialo (CII Lasoo) 8.04 8.ò8 8.ò4 8.66
Nominal oxchango ialo 8.26 2.81 1.80 8.66
1oims of liaoo 1.71 2.84 2.26 2.46
Impoils 8.28 1.02 1.01 1.82
Auto-correlation
Ioal oxchango ialo 0.81 0.76 0.76 0.72
GDI 0.87 0.72 0.78 0.66
Correlation with real exchange rate
Nominal oxchango ialo 0.06 0.68 0.00 1.00
1oims of liaoo 0.8ò 0.88 0.20 -0.08
Cioss-counliy consumplion ialio -0.4ò 1.00 1.00 1.00
Correlation with nominal exchange rate
Impoil piicos 0.4ò 0.ò8 0.ò8 0.71
CII loyol -0.17 0.1ò -0.ò4 0.68
Dierence between cross-correlation of
GDI ano Consumplion 0.22 -0.26 -0.26 -0.20
Correlation with GDP
Nol oxpoils -0.ò1 0.68 0.68 0.60
40
Table 4A. Estimates of ERPT coecients for Import Prices in articial data
o
Lconomy wilh o = 2. . = 0.ò
Specications FloxiLlo piicos
Slicky piicos
low 1C1
Slicky piicos
high 1C1
Sliucluial
Shoil iun 0.08 0.27 0.04
Long iun 0.08 0.08 0.08
Naiyo: 1
f.t
= c ÷1
t
÷c
2
1
f.t1
Shoil iun <0.01 <0.01 <0.01
Long iun 1.ò0 1.46 1.11
I1M: 1
f.t
= c ÷1
t
÷1

f.t
÷c
1
1
h.t
÷c
2
1
f.t1
Shoil iun 0.02 0.ò0 0.20
Long iun 0.08 0.04 0.06
LII1 (1): 1
f.t
= c ÷1
t
÷\

t
÷c
1
1
t
÷c
2
1
f.t1
Shoil iun 0.17 0.18 0.10
Long iun 1.00 1.00 1.00
LII1 (2): 1
f.t
= c ÷1
t
÷\

t
÷c
1
1
h.t
÷c
2
1
f.t1
Shoil iun 0.80 0.27 0.17
Long iun 0.88 0.00 0.02
o
Soo main loxl foi a oosciiplion of lho oiloionl moool oconomios ano lho spocilcalion of lho iogiossion
moools.
41
Table 4B. Estimates of ERPT coecients for Import Prices in articial data
o
Economy with o = ò. . = 1.ò
Specications FloxiLlo piicos
Slicky piicos
low 1C1
Slicky piicos
high 1C1
Sliucluial
Shoil iun 0.08 0.27 0.04
Long iun 0.08 0.08 0.08
Naiyo: 1
f.t
= c ÷1
t
÷c
2
1
f.t1
Shoil iun <0.01 <0.01 <0.01
Long iun 0.26 0.86 1.1ò
I1M: 1
f.t
= c ÷1
t
÷1

f.t
÷c
1
1
h.t
÷c
2
1
f.t1
Shoil iun 0.02 0.60 0.24
Long iun 0.08 0.88 0.74
LII1 (1): 1
f.t
= c ÷1
t
÷\

t
÷c
1
1
t
÷c
2
1
f.t1
Shoil iun 0.08 0.06 0.06
Long iun 1.00 1.00 1.00
LII1 (2): 1
f.t
= c ÷1
t
÷1

f.t
÷c
1
1
t
÷c
2
1
f.t1
Shoil iun 0.00 0.ò1 0.18
Long iun 0.00 1.00 1.00
o
Soo main loxl foi a oosciiplion of lho oiloionl moool oconomios ano lho spocilcalion of lho iogiossion
moools.
42
Table 5A. Estimates of ERPT coecients for Import Prices in articial data
(Monetary shocks only)
o
Economy with o = 2. . = 0.ò
Specications
Slicky piicos
low 1C1
Slicky piicos
high 1C1
Sliucluial
Shoil iun 0.27 0.04
Long iun 0.08 0.08
Naiyo: 1
f.t
= c ÷1
t
÷c
2
1
f.t1
Shoil iun <0.01 <0.01
Long iun 00.8 1407
I1M (1): 1
f.t
= c ÷1
t
÷1

f.t
÷c
1
1
h.t
÷c
2
1
f.t1
Shoil iun 0.08 0.01
Long iun 0.11 0.02
I1M (2): 1
f.t
= c ÷1
t
÷1

f.t
÷c
1
1
t
÷c
2
1
f.t1
0.00 0.01
Shoil iun 1.01 0.08
Long iun
LII1: 1
f.t
= c ÷1
t
÷\

t
÷c
1
1
t
÷c
2
1
f.t1
Shoil iun 0.47 0.10
Long iun 1.00 1.01
o
Soo main loxl foi a oosciiplion of lho oiloionl moool oconomios ano lho spocilcalion of lho iogiossion
moools.
48
Table 5B. Estimates of ERPT coecients for Import Prices in articial data
(Monetary shocks only)
o
Economy with o = ò. . = 1.ò
Specications
Slicky piicos
low 1C1
Slicky piicos
high 1C1
Sliucluial
Shoil iun 0.27 0.04
Long iun 0.08 0.08
Naiyo: 1
f.t
= c ÷1
t
÷c
2
1
f.t1
Shoil iun <0.01 <0.01
Long iun 07.7 08.2
I1M (1): 1
f.t
= c ÷1
t
÷1

f.t
÷c
1
1
h.t
÷c
2
1
f.t1
Shoil iun -0.11 0.02
Long iun -0.11 0.0ò
I1M (2): 1
f.t
= c ÷1
t
÷1

f.t
÷c
1
1
t
÷c
2
1
f.t1
Shoil iun 0.14 0.02
Long iun 1.01 1.08
LII1: 1
f.t
= c ÷1
t
÷\

t
÷c
1
1
t
÷c
2
1
f.t1
Shoil iun 0.48 0.12
Long iun 1.00 1.00
o
Soo main loxl foi a oosciiplion of lho oiloionl moool oconomios ano lho spocilcalion of lho iogiossion
moools.
44