Low pass-through and international synchronization in general equilibrium: Reassessing vertical integration

We investigate the difficulties of the canonical open New Keynesian model to i) reproduce the observed exchange rate pass-through disconnect, i.e. a pass-through high for import prices and low for consumer prices, and ii) to generate international business cycle synchronization. The literature tackled them separately: i) strategic complementarities for exporting firms to mitigate the pass-through to consumer prices and ii) intermediate inputs trade to enhance cross-border spillovers. We prove that foreign intermediate inputs also efficiently address the pass-through dimension, but, unlike strategic complementarities, solve the exchange rate pass-through disconnect puzzle. These results carry over to the general equilibrium effects of a depreciation. Furthermore, we show analytically that both types of vertical integration weaken sharply the expenditure switching effect. This feature strengthens real synchronization in response to productivity and monetary policy shocks, but lowers it in response to private demand shocks, a point which complements the existing literature.