Prices and Exchange Rates: A Theory of Disconnection
Jose Antonio Rodriguez Lopez
I present partial and general equilibrium versions of a sticky-wage model of exchange rate pass-through with heterogeneous producers and endogenous markups. The model's results are consistent with a story of substantial expenditure-switching effects of exchange rate changes in the presence of low levels of exchange rate pass-through to firm-level and aggregate import prices. After an exchange rate shock, aggregate import prices are subject to a survivorship bias due to changes in the extensive margin of trade. At the firm level, each producer adjusts its markups depending on its own productivity and the change in the competition environment generated by the exchange rate movement. Firm-level price responses are asymmetric -- different for appreciations and depreciations -- and adjustments in the intensive margin of trade are substantial. The general equilibrium model, solved with a second-order solution method, preserves the partial equilibrium results and shows how firm relocations increase the persistence of exogenous shocks.
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