Price adjustment and exchange rate pass-through

• Published in: Journal of international money and finance 2010-02, Vol.29 (1), p.181-200
• Main Authors: Devereux, Michael B., Yetman, James
• Format: Article
• Language: English
• Subjects: Calvo pricing; Economic models; Exchange rate pass-through; Exchange rate pass-through Calvo pricing; Exchange rates; Foreign exchange rates; Inflation; Monetary economics; Price level; Price theory; Prices; Sticky prices; Studies; Transmission mechanism
• ISSN: 0261-5606; 1873-0639
• DOI: 10.1016/j.jimonfin.2008.12.009

This paper develops a simple theoretical model that can be used to account for the determinants of exchange rate pass-through to consumer prices. While recent evidence has found low estimates of pass-through in many countries, there is little consensus on an explanation for this. Our paper argues that sticky prices represent a key determinant of exchange rate pass-through. We make this argument in two stages. First, holding the frequency of price change constant, we show that our model calibrated to data from low-inflation countries can reproduce the estimates of very low pass-through for these countries. The principal determinant of low pass-through in this case is the slow adjustment of prices. We then extend the model to allow the frequency of price change to be endogenous. Calibrating to a wider set of countries, including both low-inflation and high-inflation countries, we show that our model implies that exchange rate pass-through is increasing in average inflation, but at a declining rate. Performing the identical exercise on the data, we find a striking correspondence between the predictions of the model and those of the data.