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Modeling Exchange Rate Passthrough After Large Devaluations

  • Ariel Burstein

    (University of California at Los Angeles)

  • Martin Eichenbaum

    (Northwestern University, NBER, and Federal Reserve of Chicago.)

  • Sergio Rebelo

    (Northwestern University, NBER, and CEPR.)

Large devaluations are generally associated with large declines in real exchange rates. Burstein, Eichenbaum, and Rebelo (2005) argue that the primary force causing these declines is often the slow adjustment in the price of nontradable goods and services. We develop a model which embodies two complementary forces that account for the large declines in the real exchange rate that occur in the aftermath of large devaluations. The first force is sticky nontradable goods prices. Instead of simply assuming that nontradable goods prices are sticky, we develop conditions under which this phenomenon can emerge as an equilibrium outcome. The second force is the impact of real shocks that often accompany large devaluations. These real shocks lead to a decline in the price of nontradable goods relative to traded goods. We argue that sticky nontradable goods prices generally play an important role in explaining post-devaluation movements in real exchange rates. However, there are cases in which sticky nontradable goods prices are not sustainable as an equilibrium phenomenon. In these cases real shocks are the primary driver of real exchange rate movements.

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File URL: http://rcer.econ.rochester.edu/RCERPAPERS/rcer_514.pdf
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Paper provided by University of Rochester - Center for Economic Research (RCER) in its series RCER Working Papers with number 514.

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Length: 35 pages
Date of creation: Apr 2005
Date of revision:
Handle: RePEc:roc:rocher:514
Contact details of provider: Postal: University of Rochester, Center for Economic Research, Department of Economics, Harkness 231 Rochester, New York 14627 U.S.A.

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