Ination and Exchange Rate Pass-Through: a

Quantitative Assessment of Theoretical and

Empirical Models
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
April 2005
PRELIMINARY AND INCOMPLETE
1
Wo lhank Jon Fausl. Linoa GoloLoig. ano sominai pailicipanls al lho Lank of Ioilugal. lho 2004
Socioly foi Lconomic Dynamics moolings ano lho woikshop 1ho Impoilanco of lho Lxloinal Dimonsion
foi lho Luio Aioa: 1iaoo. Capilal Flows. ano Inloinalional Maciooconomic Linkagos." hosloo Ly lho
Luiopoan Conlial Lank. Giancailo Coisolli woik on lhis papoi is pail of lho Iioiio Woinoi Chaii in
Monolaiy Union al lho IoLoil Schuman Conloi foi Aoyancoo Sluoios of lho LUI. 1ho yiows oxpiossoo
hoio aio lhoso of lho aulhois ano oo nol nocossaiily iolocl lho posilions of lho LCL. lho Loaio of Goy-
oinois 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 0016. 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 201. USA: omail:
Sylyain.Loouc^.fiL.goy.
Abstract
1his papoi ooyolops a ouanlilaliyo opon-oconomy moool lo inyosligalo lho conliiLulions of piico
oisciiminalion ano nominal iigioilios lo lho oLsoiyoo low oogioo of oxchango-ialo pass-lhiough
ano local cuiioncy piico slaLilily. In oui fiamowoik. piico oisciiminalion iosulls fiom lho
piosonco of oisliiLulion soiyicos which makos lho olaslicily of oomano oiloi acioss maikols. As
a iosull. oui moool piooicls a long-iun oxchango-ialo pass-lhiough coomcionl of 8/ ano 48/
on impoil piicos al lho Loiooi ano al lho iolail loyol. iospocliyoly. Oyoi shoil hoiizons. a small
amounl of nominal iigioilios lowoi lhoso yaluos lo 14/ ano 7/. Afloi oocumonling lho Lusinoss
cyclo piopoilios of oxchango ialos ano piicos in lho lhooiolical oconomios. wo compaio lho
poifoimanco of lwo pass-lhiough iogiossion moools alloinaliyoly usoo in lho ompiiical liloialuio
wilh lho sliucluial foaluios of lho oiloionl aililcial oconomios. Using simulaloo limo soiios.
wo show lhal lhoso ompiiical moools. oospilo suloiing fiom moasuiomonl oiiois ano omilloo
yaiiaLlos Lias. poifoim suipiisingly woll. ospocially in oconomios chaiacloiizoo Ly a high nominal
oxchango ialo yolalilily.
1 Introduction
1ho slow ano incomplolo pass-lhiough of oxchango ialo moyomonls inlo impoil piicos ano
oomoslic inlalion is a oolning foaluio of lho inloinalional oconomy. Lolwoon 2002 ano 2004.
foi inslanco. lho oollai oopiocialoo 1/ on a liaoo-woighloo Lasis. Lolh in ioal ano in nominal
loims. ano 26/ againsl lho majoi cuiioncios. Yol. oyoi lho samo poiioo. lho impoil piico of
non-polioloum gooos has iison only Ly /: coio consumoi piicos ioso Ly 4.7/.
1ho liloialuio has ioonliloo soyoial slylizoo facls on piicos ano oxchango ialos. Fiisl. lho
olaslicily of consumoi piicos lo oxchango-ialo moyomonls is ouilo low. oyon in lho caso of yoiy
laigo nominal ooyalualions. Foi inslanco. Luisloin. LichonLaum ano IoLolo [200[ oocumonl
lhal in lho afloimalh of cuiioncy ciisos in Lasl Asia ano Lalin Amoiica lho incioaso in lho CII
has gonoially Loon 10 limos smalloi lhan lhal in lho nominal oxchango ialo. Socono. oxchango
ialo pass-lhiough inlo impoil piicos is highoi lhan lho consumoi piico olaslicily. Lul cloaily fai
fiom complolo. Lasoo on a samplo of 76 ooyoloping ano inousliializoo counliios. Fiankol. Iaisloy
ano Woi [2004[ lno lhal. oyoi a ono yoai hoiizon. impoil piicos in lho local cuiioncy iolocl on
ayoiago aiouno 60/ of oxchango ialo luclualions lhioo limos as much as lho consumoi piico
inoox. which only iolocls 20/ of oxchango ialo moyomonls. 1hiio. lho oogioo of pass-lhiough
yaiios oyoi oiloionl limo hoiizons: il is lypically ouilo low in lho shoil iun. Lul iisos wilh limo
wilhoul nocossaiily Locoming complolo in lho long iun. Foi inslanco. using oiloionl molhoos.
Campa ano GoloLoig [2002[ concluoo lhal acioss OLCD counliios lho ayoiago oxchango ialo
pass-lhiough inlo impoil piicos is 46/ in lho shoil iun. ano 64/ oyoi lho long iun. Finally. lho
oogioo of pass-lhiough (lo Lolh lho CII ano impoil piicos) sooms lo hayo fallon sinco lho oaily
1000s. a poinl oiscussoo Ly 1ayloi [2000[ ano Fiankol. Iaisloy ano Woi [2004[ among olhois.
Againsl lho woallh of ompiiical oyioonco oocumonling lhoso facls. lho oconomic mochanisms
unooilying incomplolo pass-lhough aio suLjocl lo a fai-ioaching ooLalo (soo lho suiyoy in Golo-
Loig ano Knolloi [1007[). 1iaoilional oxplanalions slioss lho iolo of nominal piico iigioilios.
Ioconlly. howoyoi. lhis yiow has Loon challongoo on Lolh lhooiolical ano ompiiical giouno. In
lho woios of Chailos Lngol (200. p. 8) lnoing lhal piicos oo nol iospono much lo oxchango
ialos is oimcull lo inloipiol oilhoi as suppoil oi conliaoiclion foi lho nolion lhal nominal
piicos aio slicky." 1ho ioason is lhal. inooponoonlly of nominal fiiclions. incomplolo oxchango
ialo pass-lhiough can iosull fiom piico oisciiminalion. i.o. oplimal ooslinalion-spocilc maikup
1
aojuslmonl Ly lims.
Unooislanoing lho iolaliyo impoilanco of oiloionl faclois causing a low pass-lhiough is
ciucial Lolh foi moool Luiloing ano policy analysis. 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 woulo coiiospono lo oplimal piicing slialogios Ly lims. In
lho piosonco of nominal iigioilios. insloao. lhoy woulo coiiospono lo suLoplimal luclualions of
lims` piolls. Honco. nominal oxchango ialos may nol play lho slaLilizing iolo alliiLuloo lo
lhom Ly lho iocoiyoo wisoom. oilhoi as a suLslilulo foi iolaliyo piico aojuslmonl in lho piosonco
of nominal iigioilios. oi as aulomalic mochanisms of iisk insuianco whon maikols aio incomplolo.
Luiloing on inloinalional Lusinoss cyclo moools wilh liaooo ano non liaooo gooos (o.g.
Slockman ano 1osai [100[). lhis papoi ooyolops a fiamowoik lo assoss analylically ano ouan-
lilaliyoly lho conliiLulion of piico oisciiminalion ano nominal iigioilios lo lho low oogioo of
oxchango-ialo pass-lhiough inlo consumoi ano piooucoi piicos oLsoiyoo in lho oala. Fiisl. as
in Coisolli ano Dooola [2008[. wo spocify a moool in which oisliiLulion soiyicos inlonsiyo in
local inpuls inouco oiloioncos in oomano olaslicilios acioss counliios. 1hus. oyon in lho aLsonco
of nominal iigioilios. lho law of ono piico woulo nol holo in gonoial. as lims oplimally chaigo
oiloionl piicos in lho oomoslic ano foioign maikols. ano oo nol moyo piicos ono-lo-ono wilh ox-
chango ialo moyomonls lho oogioo of pass-lhiough ooponoing on lho lypo ano poisislonco of
lho shocks hilling lho oconomy. Moiooyoi. ouo lo oisliiLulion. impoil piicos al iolail loyol will
nol moyo in piopoilion impoil piicos al lho Loiooi. Socono. wo assumo lhal foioign oxpoilois
faco fiiclions in aojusling piicos in local cuiioncios. Honco. wo complomonl onoogonous piico
oisciiminalion Ly lims wilh nominal iigioilios.
Wo sluoy foui oconomios: ono wilh loxiLlo piicos. lwo wilh loxiLlo wagos Lul oiloionl
piico aojuslmonl cosls. ano ono wilh nominal wago iigioilios. Foi lhoso oconomios. wo will
lisl oiscuss lhoii aLilily lo capluio lho main foaluios of oxchango ialos ano iolaliyo piicos
moyomonls in lho inloinalional Lusinoss cyclo. As shown in Coisolli. Dooola. ano Loouc [2008[.
oui moool wilh loxiLlo piicos can gonoialo highly yolalilo inloinalional piicos ano can accounl
foi poisislonl ano highly coiiolaloo moyomonls in ioal ano nominal oxchango ialos ano ooyialions
fiom lho law of ono piico in accoio lo lho oala. 1hoso piopoilios aio inhoiiloo Ly oui moools
wilh nominal iigioilios. Spocilcally. in all oui oconomios ooyialions fiom lho law of ono piico
2
conliiLulo signilcanlly lo changos in ioal oxchango ialos: lho nominal oxchango ialo is sliongly
ano posiliyoly coiiolaloo wilh lho loims of liaoo. whilo lho piico of impoils Lul only yoiy woakly
wilh lho consumoi piico loyol. OLslfolo ano Iogol [2000[ hayo aiguoo lhal ouanlilaliyo moools
of lho link Lolwoon oxchango ialos ano piicos shoulo Lo consislonl wilh lho aLoyo slylizoo facls.
1o analyzo oiloionl lhooiios of incomplolo pass-lhough in oolail. wo lisl uso oui moool lo
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 allows us lo accounl foi lho nominal ano ioal ooloiminanls
of pass-lhiough in lho shoil ano lho long iun consislonl wilh lho iosulls fiom lho ompiiical
liloialuio lhal. lypically. pass-lhiough is inilially low ano iisos oyoi limo. In a sliucluial sonso.
oui moool piooicls a long-iun oxchango ialo pass-lhiough coomcionl on impoil piicos as high
as 0.8. coiiosponoing lo maikup aojuslmonls Ly lims lhal piico-oisciiminalo acioss nalional
Loioois. In lho shoil iun. assuming lhal piicos aio kopl lxoo foi 4.8 monlhs. in lino wilh lho
oyioonco in Lils ano Klonow [2004[. lowois lhis yaluo lo 0.14 whilo nominal wago iigioilios hayo
yiilually no olocl on il. Al lho consumoi-piico loyol of impoiloo gooos. oui moool gonoialos
oxchango-ialo pass-lhough coomcionls lhal aio half as laigo as lhoso foi impoil piicos. ano
oyon much lowoi foi lho aggiogalo CII. Nolico lhal. consislonl wilh Gioyannini [1088[. Maislon
[1000[. ano Campa ano GoloLoig [2002[. wo lno lhal impoifocl oxchango-ialo pass-lhiough lasls
longoi lhan lho poiioo in which piicos aio slicky. Oyoiall. wo yiow lhoso lnoings as Loing in
lino wilh lho ompiiical oyioonco.
In lighl of oui analylical oissoclion of lho ooloiminanls of impoifocl pass-lhiough. oui moool
pioyioos a uniouo lool assoss lho poifoimanco of iogiossion moools commonly usoo in lho om-
piiical liloialuio on pass-lhiough. As is woll known. Locauso of oala limilalions. il is yiilually
impossiLlo lo Luilo ompiiical iogiossion moools lhal aio fioo fiom omilloo yaiiaLlo Lias anooi
moasuiomonl oiiois. Using lho limo soiios simulaloo fiom oui moools. wo iun lwo lypical io-
giossions lhal wo ouL Iiicing lo Maikol (I1M) ano Lxchango Ialo Iass-lhiough (LII1)
ano assoss oui iosulls againsl lho sliucluial piopoilios of oui oconomios. Lolh iogiossion
spocilcalions (I1M ano LII1) ioly on pioxios of lho liuo maiginal cosls ano ignoio oisliiLu-
lion cosls GoloLoig ano VoiLoyon [2001[ pioyioo oyioonco lhal lho lalloi aio an impoilanl
ooloiminanl of local cuiioncy piico slaLilily. Dospilo lhoso oolcioncios. wo lno lhal lho Lolh
ompiiical iogiossion moools soom lo poifoim in an oyoiall salisfacloiy way whon iun on oui sim-
8
ulaloo limo soiios. Lolh spocilcalions aio aLlo lo oislinguish Lolwoon shoil-iun ano long-iun
pass-lhiough whon lho lwo sliucluial coomcionls aio oiloionl ano coiioclly sol lhoii oslimalos
ooual whon lhoy aio lho samo. Whilo lho I1M spocilcalion ooos yoiy woll in iocoyoiing lho coi-
iocl yaluo of lho long iun sliucluial coomcionl. iogaioloss of lho piosonco of nominal iigioilios.
lho LII1 spocilcalion oisplays a oownwaio Lias in ils long-iun oslimalos as laigo as 800 poi-
conl. whon lho oogioo of piico slickinoss is laigo. Giyon lhal in lhis caso lho nominal oxchango
ialo piooicloo Ly oui moool is nol as (iolaliyoly) yolalilo as in lho oala. oui oxpoiimonl suggosls
lhal lho moasuiomonl oiioi in lho pioxios foi unoLsoiyaLlos incluooo in lhis spocilcalion. i.o.
Foioign nominal wagos foi maiginal cosls. is loo laigo lo Lo olsol Ly lho yaiiaLilily in lho olhoi
iogiossois of inloiosl. nolaLly lho oxchango ialo.
Il is woilh sliossing lhal. foi lho Lonchmaik oconomy wilh a limiloo oogioo of LCI. lho
oslimaloo coomcionl aio 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 64/ oyoi lho long iun. 1o lho oxlonl
lhal ompiiical oslimalos aio ioliaLlo. oui iosulls suggosl lhal only a limiloo amounl of nominal
iigioilios (consislonl wilh lho oyioonco in Lils ano Klonow [2004[) is ioouiioo foi lho lhooiolical
oconomy lo Lo consislonl wilh lhis oimonsion of lho oala.
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 lhon assoss lho poifoimanco of oui fiamowoik ano
lhal of ompiiical moools of pass-lhiough. 1ho lasl soclion concluoos.
2 The model
In lhis soclion. wo ooyolop oui moool. In lho noxl soclion. wo will omploy slanoaio numoiical
lochniouos lo solyo il. wilh lho spocilc goal of ouanlifying lho oogioo of oxchango-ialo pass-
lhiough in oui oconomy whon il is hil Ly monolaiy ano piooucliyily shocks.
1ho woilo oconomy consisls of lwo counliios of ooual sizo. H ano 1. Lach counliy spo-
cializos 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 / 2 [0. 1[ in lho Homo
counliy ano 1 2 [0. 1[ in lho Foioign counliy. In aooilion. oach counliy piooucos an aiiay of
4
oiloionlialoo nonliaoaLlos. inooxoo Ly : 2 [0. 1[. Nonliaooo gooos aio oilhoi consumoo oi usoo
lo mako inloimooialo liaoaLlo gooos / ano 1 ayailaLlo lo oomoslic consumois.
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-
holoswoikois aio inooxoo Ly , 2 [0. 1[ in lho Homo counliy ano ,

2 [0. 1[ in lho Foioign

counliy. Fiims opoialing in lho oisliiLulion socloi. Ly conliasl. aio assumoo lo opoialo un-
ooi poifocl compolilion.
1
1hoy Luy liaoaLlo gooos ano oisliiLulo lhom lo consumois using
nonliaooo gooos as lho only inpul in pioouclion.
In oui Lasolino moool. piicos ano wagos will Lo assumoo lo Lo poifoclly loxiLlo. In alloinaliyo
spocilcalions. wo will inlioouco nominal piico ano wago iigioilios. Ly assuming lhal woikois ano
lims faco a ouaoialic cosl of aojusling lho nominal wago ano lho gooos` piicos. iospocliyoly.
2
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

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 inyaii-
1
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.
2
Christiano, Eichenbaum and Evans [2003] and Smets and Wouters [2001] are recent structural models pro-
viding evidence that wage stickiness is an important determinant of macroeconomic uctuations.

anl oisliiLulion of woallh. inooponoonl of inilial conoilions.

3
Wo assumo lhal housoholos aio
monopolislically compoliliyo ano supply a oiloionlialoo laLoi soiyico lo lims.
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
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
1
. C
F.t
(,)

1
0
C
t
(1. ,)

H
1

H
d1

H
1
.
C
N.t
(,)

1
0
C
t
(:. ,)

N
1

N
d:

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 t1. 1hoy pay non-oisloilionaiy (lump-sum) nol laxos T. oonominaloo in Homo
cuiioncy ano a cosl whon nominal wagos aio changoo. Housoholos uso lhoii oisposaLlo incomo
3
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
lo consumo ano inyosl. 1ho inoiyioual low Luogol consliainl foi lho iopiosonlaliyo agonl , in
lho Homo counliy is lhoiofoio:
4
'
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
H.t
1
t
(,) 1
t
C
W
t
(,)
whoio E
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. Following Kim [2000[. lho
wago-aojuslmonl cosl is giyon Ly lho following ouaoialic funclion:
5
C
W
t
(,) =
i
&
2

\
t
(,)
\
t1
(,)

2
\
t
1
t
.
Wo assumo lhal inyoslmonl is caiiioo oul in Homo liaoaLlo gooos 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
.
Moiooyoi. conliaiy lo lho consumplion of liaoaLlos. wo assumo lhal inyoslmonl is nol suLjocl
lo oisliiLulion soiyicos. 1ho piico of inyoslmonl is lhoiofoio lho wholosalo piico of lho oomoslic
liaooo gooo. 1
H.t
. 1ho law of molion foi lho aggiogalo capilal slock is giyon Ly:
1
t+1
= 1
t
(1 c)1
t
()
1ho housoholo`s pioLlom lhon consisls of maximizing lifolimo ulilily. oolnoo Ly (1). suLjocl
lo lho consliainls (4) ano ().
4
BH;t denotes the Home agent's bonds accumulated during period t 1 and carried over into period t.
5
Here we abstract from issues in ination persistence that could be easily analyzed, for instance, by assuming
a form of indexation to past ination. See, e.g., Smets and Wouters [2002].
7
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.
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 (/) = 71 (/)
1
1(/)

1 (:) = 71 (:)
1c
1(:)
c
.
whoio 7 is an oconomy-wioo ianoom oisluiLanco following a slalislical piocoss lo Lo ooloiminoo
Lolow. Wo assumo lhal capilal ano laLoi aio fiooly moLilo acioss soclois.
Lol 1(/. ,) oonolo lho oomano foi laLoi inpul of lypo , Ly lho piooucoi of gooo /. Ly lho
samo lokon. 1(:. ,) oonolos lho coiiosponoing oomano foi laLoi inpul ,. Aggiogalo laLoi inpul
in lho pioouclion of lho Homo liaooo ano nonliaooo gooos aio. iospocliyoly:
1
t
(/) =

1
0
1
t
(/. ,)

L
1

L
d,

L
1
. 1
t
(:) =

1
0
1
t
(:. ,)

L
1

L
d,

L
1
: (6)
whoio 0
L
is lho olaslicily of suLslilulion among laLoi inpuls. which is lho samo acioss soclois.
Oui spocilcalion of lho oisliiLulion socloi is in lho spiiil of lho faclual iomaik Ly 1iiolo
([100[. pago 17) lhal pioouclion ano iolailing aio complomonls. ano consumois oflon consumo
lhom in lxoo piopoilions". As in Licog ano Loyin [100[ 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
1
. (7)
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
8
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.
6
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.
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

. (8)
whoio 1
N.t
is lho (consumoi) 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
(0)
Nolo lhal nominal wago iigioilios oo nol lianslalo inlo piico iigioilios: lho piico of lho nonliaooo
gooo j
t
(:) in facl moyos inyoisoly wilh piooucliyily in lho socloi.
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
. (10)
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
(/) E
t
j

t
(/)1

t
(/)[
\

t
1
1
t
7
H.t
[1
t
(/) 1

t
(/)[ (11)
6
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
whoio
1
t
(/) =

1
H.t
j
t
(/) :1
N.t

0
H
1
H.t
. 1

t
(/) =

H.t
j

t
(/) :1

N.t

H
1

H.t
. (12)
Making uso of (0). lho oplimal wholosalo piicos 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
\

t
1
1
t

t
1
1
t
7
H.t
. (18)
E
t
j

(/) =
0

H
0

H
1

1
:
0

H
0

N
0

N
1
7
H.t
7

N.t
E
t
\
c
t
1
1c
t
\

t
1
1
t

t
1
1
t
7
H.t
. (14)
whoio E
t
is lho nominal oxchango ialo. oxpiossoo in unils of homo cuiioncy unils. Unliko lho
caso of nonliaooo gooos (0). in lhis caso lho maikups chaigoo Ly lho Homo lims incluoo a
slalo-conlingonl compononl in Liackols in lho aLoyo oxpiossion lhal yaiios as a funclion
of piooucliyily shocks. monolaiy innoyalions (alocling lho oxchango ialo) ano iolaliyo wagos.
Lol :/
H.t
ano :/
H

.t
oonolo lho slalo conlingonl compononl of maikups:
:/
H.t
= 1
:
0
H
0
N
0
N
1
7
H.t
7
N.t
\
c
t
1
1c
t
\

t
1
1
t
. (1)
:/
H

.t
= 1
:
0

H
0

N
0

N
1
7
H.t
7

N.t
E
t
\
c
t
1
1c
t
\

t
1
1
t
. (16)
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
(/) 6= E
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 anooi facloi piicos.
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:
C
j
H.t
(/) =
i
j
H
2

j
t
(/)
j
t1
(/)

2
1
H.t
. C
j
H.t
(/) =
i
j
H
2

t
(/)
j

t1
(/)

2
1
H.t
.
10
ano
C
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 C
j
H.t
(/) ano C
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
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
. (17)
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
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
6= 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 [100[. who caliLialo lhoii moools lo lho a sol of OLCD
counliios. ano Chaii. Kohoo ano McGiallan [2002[. 1hioughoul lho oxoiciso. wo will caiiy oul
sonsiliyily analysis ano assoss lho ioLuslnoss of oui iosulls unooi lho Lonchmaik caliLialion.
11
Productivity shocks Lol lho yocloi Z f7. 7

g iopiosonl lho oconomy-wioo lochnology

shocks in lho oomoslic ano foioign oconomios. Wo assumo lhal oisluiLancos lo lochnology
follow a liono-slalionaiy AI(1) piocoss
Z
0
= Z u. (18)
whoioas u (n. n

) has yaiianco-coyaiianco maliix \ (u). ano is a 2r2 maliix of coomcionls

oosciiLing lho aulocoiiolalion piopoilios of lho shocks. Sinco wo assumo a symmoliic oco-
nomic sliucluio acioss counliios. wo also imposo symmoliy on lho aulocoiiolalion ano yaiianco-
coyaiianco maliicos of lho aLoyo piocoss. Following Lackus. Kohoo. ano Kyolano [1002[. wo sol
lho aulocoiiolalion ano cioss-coiiolalion of shocks lo Lo ooual lo 0.006 ano 0.088. iospocliyoly.
1ho slanoaio ooyialion of lho innoyalions is sol lo 0.0082 ano lhoii coiiolalion lo 0.22 (soo
Lollom panol of 1aLlo 1).
Monetary policy In lho Lonchmaik oconomy. monolaiy policy is sol accoioing lo an inloiosl-
ialo foooLack iulo. Oui Lasolino inloiosl-ialo iulo is similai lo lhal oslimaloo Ly Claiioa. Gali
ano Goilloi [2000[ ano usoo in a similai solling Ly Chaii. Kohoo ano McGiallan [2002[:
i
t
= ji
t1
(1 j)w

(
t
) (1 j)w
&
(1
t


1 ) -
j.t
. (1)
whoio ano

1 aio sloaoy-slalo loyols of inlalion ano oulpul. Following Chaii. Kohoo ano
McGiallan [2002[. wo sol j lo 0.70. w

lo 2.1. ano w
&
lo 0.084. 1ho innoyalion. -
j
. is
assumoo lo Lo inooponoonlly noimally oisliiLuloo wilh a slanoaio ooyialion of 0.2 poiconl.
Preferences and production Consiooi lisl lho piofoionco paiamolois. Assuming a ulilily
funclion of lho 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. (10)
wo sol c so lhal in sloaoy slalo. ono lhiio of lho limo onoowmonl is sponl woiking: o (iisk
ayoision) is sol ooual lo 2. In oui Lonchmaik caliLialion. wo sol ooual lo o. 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
12
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 6= 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 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.
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 0 poiconl. ooponoing on lho inousliial socloi. Wo follow lhoii caliLialion
ano sol il ooual lo 0 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 1 poiconl of aggiogalo
oulpul in sloaoy slalo. which coiiosponos lo lho samo ialio foi lho U.S. in lho ioconl poiioo.
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 0 poiconl whon
onoigy gooos aio oxcluooo.
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 [100[. 1hoy calcu-
lalo lhoso shaios lo Lo ooual lo 61 poiconl ano 6 poiconl. iospocliyoly. Finally. wo sol lho
oopiocialion ialo of capilal ooual lo 10 poiconl annually.
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

.
18
whoio 'C
n
ano 'C
h
aio lho maiginal cosls in lho non-liaooo ano liaooo-gooos socloi. iospoc-
liyoly. Wo sol lho gioss sloaoy-slalo maikup foi oomoslic gooos lo 1.1. 1his implios lhal 0
n
(ano 0

n
) is ooual lo 7.7. Wo lhon paiamoliizo lho olaslicily of suLslilulion Lolwoon oomoslic
liaooo gooos. 0
h
ano 0

f
. so lhal lho sloaoy-slalo maikup is ioonlical acioss soclois. foi lho giyon
caliLialoo yaluo of lho oisliiLulion maigin. Finally. wo assumo lhal lho gioss maikup foi im-
poiloo gooos is 1.8. highoi lhan lhal foi oomoslic liaoaLlo gooos. ano accoioingly paiamoloiizo
0
f
ano 0

h
.
In oui spocilcalion wilh nominal piico iigioily. wo caliLialo lho piico-aojuslmonl cosl pa-
iamolois. c
h
ano c
n
. Ly noling lhal a lypical Calyo piico-solling moool implios a 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 pioLaLilily lhal
a lim musl koop ils piico unchangoo in any giyon poiioo ano lho oiscounl facloi (soo Gali
ano Goilloi [1000[). 1ho ouaoialic aojuslmonl-cosl moool giyos a similai oiloionco ooualion
foi inlalion. Lul wilh ` =
0
J
1
i
p
J

2
. J=H,N. In lino wilh lho oyioonco iopoiloo 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. iospocliyoly. 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 foui ouailois. sinco lhis
is lho yaluo oflon usoo in lho slicky-piico liloialuio.
7
1ho olaslicily of suLslilulion Lolwoon lho oiloionl laLoi inpuls. 0
l
. is sol lo 4.8. Following
lho samo ioasoning as Lofoio. assuming lhal wago conliacl aio lxoo foi foui ouailois on ayoiago.
as in Chaii. Kohoo ano McGiallan [2002[. lianslalos inlo a yaluo foi lho wago-aojuslmonl cosl
paiamoloi of 6.8.
The elasticity of substitution between Home and Foreign tradables 1ho ouanlilaliyo
liloialuio has pioposoo a yaiioly of yaluos foi lho olaslicily of suLslilulion Lolwoon liaooo gooos.
Foi inslanco. Lackus. Kyolano. ano Kohoo [100[ sol il ooual lo 1.. whoioas Hoalhcolo ano
Ioiii [2002[ oslimalo il lo Lo 0.0. Hoio. wo sol lho olaslicily of suLslilulion . lo malch lho
yolalilily of lho US liaoo-woighloo ioal oxchango ialo (againsl a Lioao aggiogalo of lho liaoing
7
In the sticky-price literature, prices are often assumed to be set for four quarters (Smets and Wouter [2003]
estimate the average duration between price changes to be eight quarters for the Euro area).
14
pailnois) iolaliyo lo lhal of U.S. GDI. ooual lo 2.24 (soo 1aLlo 2).
8
In oui Lonchmaik oconomy.
wo lno lhal . is aiouno 0.0. which (accounling foi oisliiLulion cosls) implios a sloaoy slalo
piico olaslicily of impoil of 0.1.
9
4 Business cycle properties of exchange rates and prices
Wo iopoil on lho H-Illloioo slalislics foi lho oala. lho loxiLlo piico oconomy. ano somo
yaiialions on lhal oconomy in 1aLlo 2. 1ho slalislics foi lho oala aio all compuloo wilh lho
Uniloo Slalos as lho homo counliy ano lho iosl of lho woilo as lho foioign counliy. 1hus. all
lho numLois lhal iofoi lo impoil ano oxpoil piicos. lho CII ano so on aio fiom U.S. oala. whilo
lho nominal (ioal) oxchango ialo. foi oxamplo. iofois lo lho liaoo-woighloo oxchango ialo foi
lho Uniloo Slalos (oolaloo wilh CIIs) iolaliyo lo ils liaoing pailnois. Lasoo on oala iopoiloo
Ly lho OLCD. In lho slalislics foi oxchango ialos. lho 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 King
ano Walson [1008[`s 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 acioss
100 simulalions. 1aLlo 2 iopoils lho iosulls fiom soyoial yoisions of oui moool: a Lonchmaik
loxiLlo-piico oconomy. ano lhioo oconomios wilh nominal iigioilios: a) lwo wilh oiloionl oogioos
of local cuiioncy piico slickinoss (LCI). L) ono wilh Lolh LCI ano nominal wago iigioilios.
1ho main foaluio of oui moools is lhoii aLilily lo accounl foi lho coiiolalion Lolwoon inloi-
nalional piicos ano ouanlilios. as woll as lhoii iolaliyo yolalililios. lhal wo oLsoiyo in lho oala.
Namoly. whon wo caliLialo oach spocilc yoision of lho moool as lo malch lho yolalilily of lho
ioal oxchango ialo. il can accounl foi lho nogaliyo Lackus-Smilh coiiolalion Lolwoon iolaliyo
8
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
quoted 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.
9
In Corsetti, Dedola, and Leduc [2003], we showed that the volatility of international prices is hump-shaped in
!, and thoroughly discussed the mechanism underlying this pattern. We argued that the overall performance of
the model was more in line with the data under the lower value of !: We concentrate on this case in the following
section.
1
consumplion ano lho ioal oxchango ialo. of lho oiooi of -0.8. 1ho analysis of lho oconomy wilh
loxiLlo piicos is fully ooyolopoo in Coisolli Dooola ano Loouc [2008[. Iolaliyo lo lho loxiLlo
piicos Lonchmaik. in lhis papoi wo highlighl lhal lhis impoilanl foaluio of oui moool also
chaiacloiizo oui spocilcalions incluoing nominal piico ano wago iigioilios.
Oyoiall. wo lno lhal in gonoial oui oconomios gonoialo oxchango ialos ano inloinalional
piicos lhal malch lho oala oualilaliyoly: inloinalional piico moyomonls aio yolalilo. poisislonl.
ano highly coiiolaloo. Moiooyoi. lho coiiolalion of lho nominal oxchango ialo wilh consumoi
piicos is gonoially low. Howoyoi. ouanlilaliyoly. somo spocilcalions of lho moool oo loss woll
lhan olhois along somo oimonsions. Namoly. whilo wilh a limiloo oogioo of piico iigioilios lho
yolalilily of oxchango ialos is aLoul iighl . lho poisislonco in oxchango ialo moyomonls is loo
lilllo. lho yolalilily in lho loims of liaoo loo much. Moio piocisoly. lho following iosulls omoigo.
Fiisl. lho yolalilily of lho nominal oxchango ialo ano inloinalional piicos is as high as (oi
highoi lhan) in lho oala (iocall lhal lho moool is caliLialoo lo malch lho yolalilily of lho ioal
oxchango ialo (iolaliyo lo GDI)). OLsoiyo lhal lho aooilion of a limiloo oogioo of piico slickinoss
lo oui Lonchmaik spocilcalion lowois lho yolalilily of Lolh lho nominal oxchango ialo ano lho
loims of liaoo. Liinging il moio in lino wilh lho oala. Howoyoi. lho spocilcalions wilh a highoi
oogioo of LCI gonoialo a nominal oxchango ialo lhal is loo lilllo yolalilo.
Socono. lho nominal oxchango ialo is posiliyoly coiiolaloo wilh Lolh lho ioal oxchango ialo
ano lho loims of liaoo (a woakoi cuiioncy is associaloo wilh a woisoning of lho loims of liaoo).
A posiliyo comoyomonls of lho nominal oxchango ialo ano lho loims of liaoo is sliossoo Ly
OLslfolo ano Iogol [2001[ as oyioonco againsl lho so calloo local cuiioncy piicing`. i.o. lho iooa
lhal oxpoil piicos aio complololy slicky in lho shoil iun ouo lo nominal iigioilios. In lighl of lho
ooLalo following lho poinl Ly OLslfolo ano Iogol. lho high coiiolalion lhal wo oLlain in oui
simulalions (oyon oxcossiyo iolaliyo lo lho oala) is an inliiguing iosull. Locauso il is oLlainoo
unooi lho assumplion lhal oxpoil piicos aio inoooo slicky in Luyoi`s cuiioncy. OLsoiyo howoyoi
lhal in oui oynamic solup piicos can chango alioaoy in lho lisl poiioo in which lims aio hil
Ly a shock. pioyiooo lhoy aio ioaoy lo pay lho piico aojuslmonl cosls. Honco. oui moool ooos
nol piooicl lhal a oopiocialion of lho nominal oxchango ialo will aulomalically impioyo lho
loims of liaoo. as in a lypical onyiionmonl in which piicos aio piosol foi ono poiioo. Moiooyoi.
oyon if lhoii shoil iun impacl is inoooo an impioyomonl of lho loims of liaoo. whon shocks aio
aulocoiiolaloo nominal piico aojuslmonl oyoi limo will ioyoiso lho loims of liaoo moyomonl.
16
1hiio. slanoaio moools wilh piico iigioilios Lul poifocl pass-lhiough piooicl a poifoclly
posiliyo coiiolalion Lolwoon lho oxchango ialo ano lho impoil piico inoox: a oopiocialion of
lho cuiioncy lianslalos inlo highoi impoiloo inlalion" foi lho oomoslic oconomy. In oui sim-
ulalions. insloao. lhis coiiolalion is posiliyo Lul much Lolow ono. as in lho oala: lho highosl
coiiolalion. in lho loxiLlo piico oconomy. is 0.61. ano lho lowosl is 0.8. in lho oconomy wilh
limiloo LCI. againsl 0.1 in lho oala (oxcluoing oil impoils). Ly lho samo lokon. slanoaio
moools wilh nominal iigioilios ano complolo pass-lhiough woulo piooicl a zoio coiiolalion Lo-
lwoon lho oxchango ialo ano lho oxpoil piico inoox. sinco lho lalloi is pioooloiminoo in lho
shoil iun. In oui iosulls. lhis coiiolalion is aiouno 0.0. ano is lhoiofoio much highoi lhan lhal
in lho U.S. oala. slanoing al only 0.16.
Finally. a low (onoogonous) impoil piico olaslicily ano oisliiLuliyo liaoo imply lhal Lolh
lho consumoi piicos ano inlalion aio only lonuously coiiolaloo wilh lho nominal oxchango ialo
acioss all spocilcalions in accoio lo lho oyioonco. In pailiculai. lho coiiolalion wilh lho
CII loyol acioss all spocilcalions wilh nominal iigioilios is as low ano nogaliyo as lhal in lho
oala. slanoing al -0.18 (oxcluoing onoigy). whilo lhal wilh inlalion noyoi oxcooos 0.1 in lho
lhooiolical oconomios. only slighlly lowoi lhan lho aclual yaluo of 0.10.
5 Structural and empirical pass-through equations
1ho loxlLook oolnilion of oxchango pass-lhiough (honcofoilh. LII1) is lho poiconlago chango
in impoil piicos oonominaloo in local cuiioncy iosulling fiom a ono poiconl chango in lho
Lilaloial oxchango ialo Lolwoon lho oxpoiling ano lho impoiling counliy. olhoi lhings ooual.
1oxlLook moools of lho Lalanco of paymonls. as woll as a hosl of papois in lho Now opon-oconomy
maciooconomics liloialuio. assumo a ono-foi-ono iosponso of impoil piicos lo oxchango ialos.
namoly full oi complolo LII1. NolaLly. complolo LII1 oLlains if (i) maikups oyoi cosls aio
conslanl. ano (ii) maiginal cosls aio also conslanl.
10
Unooi lhoso lwo conoilions. lho olaslicily of oomano foi impoils is a ciucial ooloiminanl
of lho iosponso of lho liaoo Lalanco lo moyomonls in lho oxchango ialo. A classical ouoslion
is wholhoi oopiocialion of a nalion`s cuiioncy impioyo ils liaoo Lalanco a ouoslion lhal is
10
A third possibility is that changes in markups just oset changes in costs in a systematic way, leaving export
prices in the exporter's currency constant.
17
of pailiculai inloiosl in a woilo wilh incomplolo lnancial maikols ano lios al lho coio of lho
oxloinal aojuslmonl ano lho cioss-Loiooi liansmission of inlalion.
In lhis soclion. wo uso oui moool (in oiloionl spocilcalions) lo ooiiyo sliucluial oxpiossions
foi pass-lhiough coomcionls in lho shoil- ano lho long-iun. 1hoso oxpiossions can Lo usoo in
spocifying ompiiical iogiossion moools which aio consislonl wilh alloinaliyo lhooiolical yiows of
pass-lhiough. Moiooyoi. Lasoo on lhoso oxpiossions. wo will Lo aLlo lo sluoy lho poifoimanco
of ompiiical iogiossion moools which. Locauso of oala ayailaLilily. oo nol oxaclly confoim wilh
oui sliucluial ooualions. Wo will also pioyioo a ouanlilaliyo assossmonl of lho iosulling Lias.
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)

E
t

[
'C

f.t

j(:/
f
1)
1 j(:/
f
1)

'C
n.t
(20)
whoio :/
f
is lho lolal maikup (incluoing Lolh oisliiLulion ano slanoaio maikup) in lho homo
impoil socloi ano j is lho oisliiLulion maigin. 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 paiamolois yaluo imply lhal
lho LII1 coomcionl is ooual lo 0.8. 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 0 poiconl. pass-lhiough lo consumoi piicos (of impoils)
falls lo 48 poiconl. As noloo Ly lho liloialuio. lho implicalions of oisliiLuliyo liaoo foi local
cuiioncy piicing is ouilo iomaikaLlo oyon in moools wilh poifocl piico loxiLilily.
5.1.2 ERPT and local currency price stickiness
Iocall lhal. in oui moool. wo hayo assumoo a slanoaio 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.
18
imposing symmoliy ano log-linoaiizing aiouno a sloaoy slalo . wo oLlain:

1
f.t
=

E
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
is ooual lo
(\

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. In
oui Lonchmaik caliLialion. lho shoil iun coomcionl can Lo as low as 2 poiconl foi a high oogioo
of nominal iigioilios. CaliLialing lho moool using lho iosulls fiom Lils ano Klonow [2004[. foi
an ayoiago nominal piico iigioilios of 4.8 monlhs. lho shoil iun coomcionl is 14 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 8 poiconl. Iocall
lhal wilh a oisliiLulion maigin of 0 poiconl. pass-lhiough onlo consumoi piicos will Lo half
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)

E
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
.
Whon Liinging lho moool lo lho oala. oui analysis makos il cloai lhal an ompiiically con-
10
sislonl spocilcalion of lho iogiossion moool woulo call foi lho inclusion of lho oxpocloo yaluo
of 1
t

1
f.t+1
. Ils omission is Louno lo iosull inlo omilloo-yaiiaLlo Lias. Wo will ioluin on lhis
poinl Lolow.
OLsoiyo lhal lho log linoai ooualion foi lho oomoslic piicos aLioao is:

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

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:

E
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 )

E
t

(:/
f
1) j
1 j(:/
f
1) i
j
F

2
(:/
f
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

f.t+1


1

f.t1

1
t

1
f.t+1


1
f.t1

As poinloo oul Ly Coisolli ano Dooola [200[. 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.
5.2 Empirical models of ERPT: an assessment using simulated 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
1
t
= c E
t
C
t
cA
t
n
t
. (21)
whoio all yaiiaLlos aio in logs: 1
t
is lho impoil piico oonominaloo in local cuiioncy. C
t
is a
moasuio of oxpoiloi`s maiginal cosls. A
t
may incluoo conliols foi shifls in impoil oomano (liko
20
compoling piicos oi incomo in lho impoiling counliy). as woll as laggoo yaluos of lho ooponoonl
yaiiaLlo lo capluio oynamics. ano E
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 C
t
is full oi complolo if = 1 ano is incomplolo if < 1.
Iioyiooo ono can lno an accuialo moasuio of maiginal cosl C
t
. lho coomcionl moasuios only
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 spocifying
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 (21). 1
t
is lho oxpoil piico. C
t
is lho oomoslic piico of lho samo gooo. whilo 1
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[).
11
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 E
t
\

t
c
1
1
t
c
2
1
f.t1
. (22)
In loims of (21). 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 oconomy wilh nominal
11
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.
21
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 E
t
1

f.t
c
1
1
h.t
c
2
1
f.t1
. (28)
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.
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 lho maikup. ano suloi fiom moasuiomonl
oiioi pioLloms. as lhoy ioly on pioxios of lho gonoially unoLsoiyaLlo maiginal cosls. Iiocisoly.
(22) 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 (28) is a polonlial souico of Lias. as lhis piico incluoos a Foioign maikol limo-
yaiying maikup.
12
Lul how fai aio lhoso ompiiical iogiossion moools fiom lho liuo yaluos of lho sliucluial
coomcionls 1ho answoi lo lhis ouoslion is ciucial foi lho ompiiical liloialuio. giyon lhal lho
pioLloms oiscussoo aLoyo aio likoly lo plaguo yiilually all applioo papois liying lo oslimalo
sliucluial LII1 ompiiically. Moiooyoi. il is woilh kooping in mino lhal lho accuiacy of LII1
oslimalos has an impoilanl policy oimonsion: lhoso oslimalos aio an impoilanl inpul inlo
piojoclions of oxchango ialo changos onlo piicos ano oulpul which unooilio monolaiy policy
oocision making.
1aLlo 8 piosonls lho iosulls of lho LII1 ano I1M iogiossions iun on oui simulaloo limo
soiios. 1ho laLlo also shows a conliol iogiossion in which lho impoil piico is iogiossoo only on
lho oxchango ialo ano ils lag wo ouL lhis spocilcalion "naiyo". 1ho oslimaloo coomcionls
12
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.
22
in lho laLlo aio ayoiagos oyoi 100 simulalions of 88 ouailois (a lypical samplo sizo). 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 Sliucluial. 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. in lho Lonchmaik moool wilh loxiLlo piicos lho shoil
iun ano long iun coomcionls coincioo. ano lhoii loyol. ooual lo 0.8. is fully ooloiminoo Ly lho
sloaoy slalo loyol of lho maikup in lho impoil socloi. :/
h
. ano lho oisliiLulion maigin. j.
Conyoisoly. in lho slicky piico moool shoil iun ano long iun LII1 coomcionls oiloi. Locauso
of lho ooslinalion-spocilc piico aojuslmonl cosl. lho shoil iun coomcionl is ooual lo 0.14. lho
long iun coomcionl is 0.8. as in lho Lonchmaik. NolaLly. lhoso yaluos aio woll in lho iango of
lho oslimalos foi lho U.S. ano in gonoial lho inousliializoo counliios (soo Anooilon [2008[ ano
Campa ano GoloLoig [2002[. iospocliyoly).
Fiom 1aLlo 8. il appoais lhal lho oyoiall poifoimanco of lho LII1 ano I1M spocilcalion
is in gonoial salisfacloiy. allhough lho coomcionl oslimalos aio somowhal Liasoo. Fiisl. Lolh
spocilcalions aio always aLlo lo oislinguish Lolwoon shoil iun ano long iun coomcionls whon
lhoy aio liuly oiloionl. ano coiioclly sol lhoii oslimalos ooual whon lhoy aio lho samo. 1his is
mosl appaionl in compaiison wilh lho "naiyo" spocilcalion. in which lho inclusion of lho laggoo
ooponoonl yaiiaLlo alono is nol onough lo oslimalo lho samo shoil iun ano long iun coomcionls
in lho caso of lho loxiLlo piico moool (soo lisl column of 1aLlo 8)
Socono. lho I1M spocilcalion ooos yoiy woll in iocoyoiing lho coiiocl yaluo of lho long iun
sliucluial coomcionl. iogaioloss of lho piosonco of nominal iigioilios. Howoyoi. ils poifoimanco
ooloiioialos wilh piico slickinoss. as a syslomalic upwaio Lias shows up in lho oslimalion of lho
shoil iun coomcionl acioss all moool yaiialions. Moiooyoi. lho unLiasoonoss of lho long iun
oslimalos highlighls lhal lho shoil iun upwaio Lias in lho oslimaloo is Lasically olsol Ly a
coiiosponoing oownwaio Lias in lho coomcionl on lho laggoo ooponoonl yaiiaLlo. c
2
. lhal will
aoyoisoly alocl lho infoionco of lho oynamics olocls of lho oxchango ialo on impoil piicos.
1hiio. allhough lho LII1 spocilcalion noyoi iocoyois lho oxacl sliucluial coomcionls. il
oulpoifoims lho "naiyo" spocilcalion foi lho casos wilh a limiloo oogioo of LCI (soo lho lisl
lwo columns). Conyoisoly. wilh a foui-ouailoi LCI slickinoss. lho oownwaio Lias in ils long-iun
oslimalos is as laigo as 800 poiconl. Giyon lhal in lhis caso lho nominal oxchango ialo is nol as
(iolaliyoly) yolalilo as in lho oala. lhis Lias may Lo aiising fiom lho facl lhal lho moasuiomonl
28
oiioi in lho pioxy foi foioign maiginal cosls incluooo in lhis spocilcalion. i.o. nominal wagos. is
loo laigo lo Lo olsol Ly lho yaiiaLilily in lho olhoi iogiossois of inloiosl. nolaLly lho oxchango
ialo. 1hus. lhis Lias is al loasl as soiious as lhal aiising fiom omilloo yaiiaLlos in lho "naiyo"
spocilcalion.
Il is woilhwhilo lo slioss lhal lho oslimaloo coomcionls foi lho oconomy wilh a limiloo
oogioo of LCI aio piolly 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 64/ oyoi lho long iun. In lighl of lho aLoyo
iosulls oocumonling lho ioliaLilily of lhoso iogiossions. il sooms ioasonaLlo lo concluoo lhal only
a limiloo amounl of nominal iigioilios is ioouiioo foi lho lhooiolical oconomy lo Lo consislonl
wilh lhis oimonsion of lho aclual oala.
5.3 ERPT coecient and pass-through
Whal conclusions lhal can Lo oiawn fiom oslimaling LII1 coomcionls Wo closo oui analysis
wilh an impoilanl cayoal. Lyon if oconomoliicians woio aLlo lo iocoyoi piociso oslimalos of
sliucluial pass-lhiough coomcionls. lhoio will slill Lo a ouoslion aLoul lhoii uso in policy-
oiionloo oxoicisos aooiossing lho impacl of spocilc shocks on impoil piicos oi. moio in gonoial.
on lho CII.
1ho main issuo is lhal. in gonoial. sliucluial pass-lhiough coomcionls aio nol a complolo
oosciiplion of lho aclual piopoilios of lho moool as iogaios lho link Lolwoon impoil piicos ano
oxchango ialos. In oach pailiculai poiioo. lhis link will Lo ooloiminoo conoilional on lho spocilc
shocks causing oxchango ialo luclualions. 1o claiify lhis poinl: in all oui spocilcalions impoil
piicos iosponos ono-lo-ono lo monolaiy shocks in lho long iun ano also in lho shoil iun in
lho Lonchmaik oconomy whoio piicos aio loxiLlo. Honco. conoilional on monolaiy oisluiLancos.
long-iun LII1 is poifocl.
Lyon lho oxchango ialo coomcionl in lho pass-lhiough ooualion is lowoi lhan ono. poifocl
pass lhiough fiom monolaiy shocks will oyonlually iosulls Locauso such oisluiLancos will Liing
aLoul iolaloo moyomonls in lho olhoi onoogonous yaiiaLlos onloiing lho sliucluial ooualion lhal
ooloiminos lho piico of impoils honco iunning againsl lho coloiis paiiLus assumplion` implicil
in inloipioling lho LII1 coomcionl in lho sliucluial iogiossions. Spocilcally. a monolaiy oasing
in lho Homo counliy lhal oopiocialos lho Homo cuiioncy will oyonlually causo a piopoilional
24
incioaso in lho nominal piico of oisliiLulion soiyicos. Iulling all olomonls logolhoi. il is oasy lo
yoiify lhal impoil piicos will oyonlually iiso ono-lo-ono wilh lho oxchango ialo. 1ho losson is
lhal using sliucluial ooualions lo foiocasl lho impacl of a nominal shock. Lul failing lo conliol
foi lho gonoial oouiliLiium olocls of such shocks. woulo pioouco an unooioslimalion of lho
iosponso of impoil piicos lo funoamonlal changos in oxchango ialos.
6 Concluding remarks
Why oo piicos iospono only pailially. if al all. lo changos in lho nominal oxchango ialo 1his
papoi ooyolops a ouanlilaliyo. oynamic. opon-oconomy moool lo assoss lho conliiLulions of piico
oisciiminalion ano local cuiioncy piicing wilh nominal iigioily lo lho 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: 8/ ano
48/ on impoil ano consumoi piicos. Moiooyoi. wo lno lhal a yoiy small amounl of nominal
iigioilios lowoi lhoso yaluos lo 10/ ano / in lho shoil iun. iospocliyoly. Finally. wo compaio lho
poifoimanco of iogiossion moools commonly usoo in lho ompiiical liloialuio. wilh lho sliucluial
foaluios of lho moool. Wo lno lhal lho iogiossion moools poifoim suipiisingly woll. oisplaying
iolaliyoly small Lias in lho oslimaloo pass-lhiough coomcionls.
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28
Table 1. Parameter values
Benchmark Model
Iiofoioncos ano 1ochnology
Iisk ayoision o = 2
Disulilily of laLoi c = 1.18
Volocily paiamoloi . = 0.1
Llaslicily of suLslilulion Lolwoon:
Homo ano Foioign liaooo gooos
1
1a
= 0.80
liaooo ano non-liaooo gooos
1
1c
= 0.74
Homo non-liaooo gooos 0
N
= 7.7
Homo liaooo gooos 0
H
= 1.8
laLoi inpuls 0
L
= 4.8
Shaio of Homo liaooo gooos a
H
= 0.88
Shaio of non-liaooo gooos a
N
= 0.48
Llaslicily of lho oiscounl facloi
wilh iospocl lo C ano 1 c = 0.006
DisliiLulion maigin j = 0. (: = 1.18)
LaLoi shaio in liaoaLlos : = 0.61
LaLoi shaio in nonliaoaLlos c = 0.6
Dopiocialion ialo c = 0.02
Iico-aojusmonl cosl c
N
= c
H
= .6
Wago-aojusmonl cosl c
W
= 68
Monolaiy Iolicy
Coolcionl of aulocoiiolalion j = 0.08
Coomcionl on inlalion c

= 1.66
Coomcionl on oulpul c
&
= 0.14
Slanoaio ooyialion of lho shock o
.
= 0.0018
Iiooucliyily shocks
Aulocoiiolalion maliix ` =

0.006 0.088
0.088 0.006

Vaiianco-coyaiianco maliix (in poiconl) \ =

0.007 0.001
0.001 0.007

20