Volatility and Pass-Through
56 Pages Posted: 16 Nov 2013
Date Written: November 2013
What drives countercyclical volatility? A large literature has documented that many economic variables are more disperse in recessions, but this could either occur because shocks get bigger or because firms respond more to shocks which are the same size. Existing evidence that the dispersion of endogenous variables rises in recessions cannot tell us which of volatility or responsiveness is getting bigger, and these two explanations have very different policy implications. However, we document new facts in the open economy environment and show that they can be used to disentangle these explanations. In particular, we use confidential BLS micro data to show that there is a robust positive relationship between exchange rate pass-through and the dispersion of item-level price changes. We then argue that changes in responsiveness can explain this fact while volatility shocks cannot.
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