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Small price change response to a large devaluation in a menu cost model

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  • Bruchez, Pierre-Alain

Abstract

In an empirical paper based on five large devaluation episodes in Argentina, Brazil, Korea, Mexico and Thailand, Burstein and al. (2005a) find a very slow adjustment in the prices of non-tradable goods and services after large devaluations. Burnstein and al. (2005b) develop a quantitative general-equilibrium model that can account for this phenomenon. I consider an alternative, simpler model and explore under which conditions moderate menu costs can explain the muted response of the prices of non-tradables. The key new element in this alternative model is a nominal friction in wage-setting (generated by menu costs for changing wages). I find, for example, that although my model is based on menu costs, it is able to deliver not only constant prices of non-tradables, but also small price changes (in reality these prices do change, albeit by far less than the exchange rate). I also discuss the existence of multiple equilibria and the role of central-bank credibility.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 3541.

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Date of creation: 03 Apr 2007
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Handle: RePEc:pra:mprapa:3541

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Keywords: large devaluation; exchange rate; pass-through; sticky prices; sticky wages;

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  1. Ariel Burstein & Martin Eichenbaum & Sergio Rebelo, 2005. "Large Devaluations and the Real Exchange Rate," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 113(4), pages 742-784, August.
  2. Kanda Naknoi, 2005. "Real exchange rate fluctuations, endogenous tradability and exchange rate regime," International Finance, EconWPA 0509004, EconWPA, revised 07 Nov 2005.
  3. Burstein, Ariel & Eichenbaum, Martin & Rebelo, Sergio, 2007. "Modeling exchange rate passthrough after large devaluations," Journal of Monetary Economics, Elsevier, Elsevier, vol. 54(2), pages 346-368, March.
  4. Huang, Kevin X. D. & Liu, Zheng, 2002. "Staggered price-setting, staggered wage-setting, and business cycle persistence," Journal of Monetary Economics, Elsevier, Elsevier, vol. 49(2), pages 405-433, March.
  5. Fishman, Arthur & Simhon, Avi, 2005. "Can small menu costs explain sticky prices?," Economics Letters, Elsevier, Elsevier, vol. 87(2), pages 227-230, May.
  6. Pablo Andres Neumeyer & Martín Gonzalez Rozada, 2003. "The elasticity of Substitution in demand for Non tradable Goods in Latin America. Case Study: Argentina," Department of Economics Working Papers, Universidad Torcuato Di Tella 027, Universidad Torcuato Di Tella.
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