A competitive search approach to exchange rate pass-through

We develop an open economy, search theoretic, monetary model with heterogeneous households which is characterized by incomplete pass-through of exchange rate movements to import price indices. Partial pass-through arises in our environment due to buyers’ responses to exchange rate movements in the presence of competitive search in international goods’ markets. Generally, in the theory of competitive search, agents choose a submarket in which to exchange goods, where different submarkets are characterized by different trading probability and price combinations. Preference and policy shocks which induce exchange rate movements cause households to choose a different submarket (store) for their purchases of traded goods—an extensive margin response. This store-switching response by households is a novel mechanism we identify that mitigates the direct effect of nominal exchange rate changes on equilibrium traded goods’ prices, thereby generating incomplete exchange rate pass-through to price indices. Due to risk aversion by households, the degree of pass-through depends on the size and direction of the initial shock, making the model consistent with the observed phenomenon of asymmetric pass-through. Importantly, by incorporating household heterogeneity, we are also able to examine the role of precautionary savings in affecting pass-through, characterize how pass-through varies across different types of households, and examine the distributional effects of exchange rate movements.