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DSGE Models of High Exchange-Rate Volatility and Low Pass-Through

Author

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  • Corsetti, Giancarlo
  • Dedola, Luca
  • Leduc, Sylvain
Abstract
This paper develops a quantitative, dynamic, open-economy model which endogenously generates high exchange rate volatility, whereas a low degree of exchange rate pass-through (ERPT) stems from both nominal rigidities (in the form of local currency pricing) and price discrimination. We model real exchange rate volatility in response to real shocks by reconsidering and extending two approaches suggested by the quantitative literature (one by Backus Kehoe and Kydland [1995], the other by Chari, Kehoe and McGrattan [2003]), within a common framework with incomplete markets and segmented domestic economies. We show that, in our framework, both approaches are successful in generating volatility without any need for nominal shocks, and without suffering from shortcomings such as a fall in import volatility. Our model accounts for a variable degree of ERPT over different horizons. In the short run, we find that a very small amount of nominal rigidities --- consistent with the evidence in Bils and Klenow [2004] --- lowers the elasticity of import prices at border and consumer level to 27% and 13%, respectively. Still, exchange rate depreciation worsens the terms of trade -- in accord with the evidence stressed by Obstfeld and Rogoff [2000]. In the long run, ERPT coefficients are also below one, as a result of price discrimination. We run a set of regressions adopted by the empirical literature on ERPT, typically plagued by omitted variable bias and measurement errors, on the time series generated by our model. The ERPT estimates are biased, although in most cases reasonable; most regressions can detect differences between short-run and long-run ERPT. We show that the quality of empirical proxies for marginal costs and demand typically vary depending on the shocks (real vs. nominal) hitting the economy.

Suggested Citation

  • Corsetti, Giancarlo & Dedola, Luca & Leduc, Sylvain, 2005. "DSGE Models of High Exchange-Rate Volatility and Low Pass-Through," CEPR Discussion Papers 5377, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:5377
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    More about this item

    Keywords

    International business cycle; Exchange rate volatility; Pass-through; International transmission; Dsge models;
    All these keywords.

    JEL classification:

    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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