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Can trade costs explain why exchange rate volatility does not feed into consumer prices?

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  • Fitzgerald, Doireann

Abstract

If countries specialize in imperfectly substitutable goods, trade costs increase the share of expenditure devoted to domestic output, reducing the exposure of consumer price inflation to exchange rate changes. I present a multi-country flexible-price model where expenditure shares are inversely related to trade costs through a gravity equation. In this setting, consumer price inflation can be approximated as an expenditure-share-weighted average of the contributions to inflation from all countries. I use data from 24 OECD countries, 1970-2003, to estimate a structural gravity model. I combine the fitted expenditure shares from the estimation with actual data on exchange rates to construct predictions of inflation. The behavior of these predictions indicates that trade costs can explain both qualitatively and quantitatively the failure of exchange rate volatility to feed into inflation.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 55 (2008)
Issue (Month): 3 (April)
Pages: 606-628

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Handle: RePEc:eee:moneco:v:55:y:2008:i:3:p:606-628

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Web page: http://www.elsevier.com/locate/inca/505566

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  12. Taylor, Alan M & Taylor, Mark P, 2004. "The Purchasing Power Parity Debate," CEPR Discussion Papers 4495, C.E.P.R. Discussion Papers.
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Cited by:
  1. Thomas A. Lubik & Katheryn N. Russ, 2012. "Exchange rate volatility in a simple model of firm entry and FDI," Economic Quarterly, Federal Reserve Bank of Richmond, issue 1Q, pages 51-76.
  2. Claudio Bravo-Ortega, 2013. "Do Multilateral Trade Linkages Explain Bilateral Real Exchange Rate Volatility?," Working Papers wp377, University of Chile, Department of Economics.
  3. repec:fip:fedreq:y:2012:i:1q:p:51-76:n:vol.98no.1 is not listed on IDEAS

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