Exchange Rates and Prices

University Of Wisconsin-Madison, Madison WI

Investigators

Abstract

This project investigates the behavior of foreign exchange rates and goods prices. It provides a new time-series analysis of aggregate consumer prices and exchange rates. It offers a framework for extending "new open-economy macroeconomic" models. The structure proposed incorporates a local sector for distribution of imported goods. The project pursues how the volatility of the exchange rate depends on the amount of "exchange-rate pass-through" to importers and to consumers, and the elasticity of demand for imported goods by consumers and the derived elasticity of demand by importer/distributors. There is further study of the pass-through question, taking into account the separate roles of consumers and importer/distributors. Finally, empirical measures of pass-through to consumers and importers, along with other parameters are derived and used to simulate these new models. The first phase of the project proposes a new way of looking at the "purchasing power parity" puzzle. Real exchange rates among advanced countries have been very volatile and extremely persistent since the collapse of Bretton Woods. The extreme volatility of the real rates seems to point to a monetary or financial force driving the exchange rate, as opposed to real productivity or taste shocks. But the standard monetary model requires that real exchange rate persistence be determined by the persistence of nominal price adjustment. This project breaks the link between the speed of adjustment of nominal exchange rates and the speed of adjustment of nominal prices implicit in such models. A new approach is developed that allows measurement of the speed of adjustment of prices and exchange rates to the equilibrium levels, using an unobserved components model. The key identifying assumption of the equilibrium levels is the long-run purchasing power parity assumption. The approach does not require that the equilibrium levels follow random walks, nor is it necessary to restrict the correlation of innovations to the equilibrium component and the transitory components. The next part of the proposal advances a framework for extending recent dynamic stochastic general-equilibrium optimizing models of open economies with sticky nominal prices. It seeks to extend the analysis, and build models that reconcile the very low levels of exchange-rate pass-through to consumers with the greater degree of pass-through to import prices. Under this framework, it should be possible to understand the implications of empirical results that find expenditure- switching effects of exchange rates at the producer level, but little expenditure switching in final goods prices. One disappointment of the new open economy macro literature is its lack of progress on understanding nominal exchange rate determination. This project pursues potential avenues for understanding the high degree of nominal exchange rate volatility. The framework for generalizing open-economy models takes pass-through parameters and elasticities of demand as given. The next part of the project develops some ideas for extending the theoretical literature on pass-through and menu-cost pricing in the context of models with importer/distributors that are distinct from final buyers. Finally, the project proposes uses disaggregated data on consumer prices in conjunction with industry-level price and import data to produce estimates of pass-through and elasticities that will help calibrate the general equilibrium models.