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Openness and Imperfect Pass-Through: Implications for the Monetary Policy

  • Claudio Soto
  • Jorge Selaive

This paper analyzes the positive and normative implications of the degree of openness of a small economy for the transmission mechanism of monetary shocks. First, we show empirical evidence on the direct relationship between openness and the degree of exchange rate pass-through. Then, we develop a general equilibrium model where countries do not fully specialize according to their comparative advantages. With this framework we show that incomplete specialization makes the pass-through from exchange rate to import prices imperfect. The less open is the country --the less specialized- the lower is the pass-through from exchange rate to import prices. Despite the fact that the pass-through is incomplete and the expenditure switching effect is diminished, the flexible price allocation can still be reached with an inward-oriented monetary policy.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 216.

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Date of creation: Jun 2003
Date of revision:
Handle: RePEc:chb:bcchwp:216
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  1. Devereux, Michael B & Engel, Charles M, 2000. "Monetary Policy In The Open Economy Revisited: Price Setting Rules And Exchange Rate Flexibility," CEPR Discussion Papers 2454, C.E.P.R. Discussion Papers.
  2. Burstein, Ariel T. & Neves, Joao C. & Rebelo, Sergio, 2003. "Distribution costs and real exchange rate dynamics during exchange-rate-based stabilizations," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1189-1214, September.
  3. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," CEPR Discussion Papers 1131, C.E.P.R. Discussion Papers.
  4. Lane, Philip R., 2001. "The new open economy macroeconomics: a survey," Journal of International Economics, Elsevier, vol. 54(2), pages 235-266, August.
  5. Pinelopi Koujianou Goldberg & Michael M. Knetter, 1997. "Goods Prices and Exchange Rates: What Have We Learned?," Journal of Economic Literature, American Economic Association, vol. 35(3), pages 1243-1272, September.
  6. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," Working Papers 042000, Hong Kong Institute for Monetary Research.
  7. Friberg, Richard & Nydahl, Stefan, 1999. "Openness and the Exchange Rate Exposure of National Stock Markets," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 4(1), pages 55-62, January.
  8. Maurice Obstfeld and Kenneth Rogoff., 1999. "New Directions for Stochastic Open Economy Models," Center for International and Development Economics Research (CIDER) Working Papers C99-107, University of California at Berkeley.
  9. Bodnar, Gordon M. & Gentry, William M., 1993. "Exchange rate exposure and industry characteristics: evidence from Canada, Japan, and the USA," Journal of International Money and Finance, Elsevier, vol. 12(1), pages 29-45, February.
  10. Engel, Charles, 2000. "Local-currency pricing and the choice of exchange-rate regime," European Economic Review, Elsevier, vol. 44(8), pages 1449-1472, August.
  11. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
  12. Edwards, Sebastian, 1998. "Openness, Productivity and Growth: What Do We Really Know?," Economic Journal, Royal Economic Society, vol. 108(447), pages 383-98, March.
  13. Charles Engel, 2003. "Expenditure Switching and Exchange-Rate Policy," NBER Chapters, in: NBER Macroeconomics Annual 2002, Volume 17, pages 231-300 National Bureau of Economic Research, Inc.
  14. Roberts, Mark J & Tybout, James R, 1997. "The Decision to Export in Colombia: An Empirical Model of Entry with Sunk Costs," American Economic Review, American Economic Association, vol. 87(4), pages 545-64, September.
  15. Betts, Caroline & Devereux, Michael B., 1996. "The exchange rate in a model of pricing-to-market," European Economic Review, Elsevier, vol. 40(3-5), pages 1007-1021, April.
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