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Price Setting and Exhange Rate Pass-Through

  • Michael B. Devereux

    (University of British Columbia
    CEPR)

  • James Yetman

    (University of Hong Kong)

There has been a considerable recent debate on the causes of low pass-through from exchange rates to consumer prices. This paper develops a simple model of a small open economy in which exchange rate pass-through is determined by the frequency of price changes of importing firms. But this, in turn,is determined by the monetary policy rule of the central bank. ¡¥Looser¡¦ monetary policy, which implies a higher mean inflation rate, and a higher volatility of the exchange rate, will lead to more frequent price changes and a higher rate of pass-through. The model implies that there should be a positive, but nonlinear, relationship between pass-through and mean inflation, and a positive relationship between passthrough and exchange rate volatility. In a sample of 122 countries, this is strongly supported by the data. Our conclusion is that, at least partly, low exchange rate pass-through is a result of short-term price rigidities.

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Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 222002.

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Length: 25 pages
Date of creation: Dec 2002
Date of revision:
Handle: RePEc:hkm:wpaper:222002
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  1. Tommaso Monacelli, 2001. "New International Monetary Arrangements and the Exchange Rate," Working Papers 54, Oesterreichische Nationalbank (Austrian Central Bank).
  2. Giancarlo Corsetti & Luca Dedola, 2002. "Macroeconomics of international price discrimination," International Finance Discussion Papers 744, Board of Governors of the Federal Reserve System (U.S.).
  3. Ariel T. Burstein & Joao C. Neves & Sergio Rebelo, 2000. "Distribution Costs and Real Exchange Rate Dynamics During Exchange-Rate-Based Stabilizations," RCER Working Papers 473, University of Rochester - Center for Economic Research (RCER).
  4. Choudhri, Ehsan U. & Hakura, Dalia S., 2006. "Exchange rate pass-through to domestic prices: Does the inflationary environment matter?," Journal of International Money and Finance, Elsevier, vol. 25(4), pages 614-639, June.
  5. Jose Manuel Campa & Linda S. Goldberg, 2002. "Exchange Rate Pass-Through into Import Prices: A Macro or Micro Phenomenon?," NBER Working Papers 8934, National Bureau of Economic Research, Inc.
  6. Michael B. Devereux & James Yetman, 2001. "Predetermined Prices and the Persistent Effects of Money on Output," Working Papers 01-13, Bank of Canada.
  7. Caroline M. Betts & Timothy J. Kehoe, 2008. "Real Exchange Rate Movements and the Relative Price of Non-traded Goods," NBER Working Papers 14437, National Bureau of Economic Research, Inc.
  8. Taylor, John B., 2000. "Low inflation, pass-through, and the pricing power of firms," European Economic Review, Elsevier, vol. 44(7), pages 1389-1408, June.
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