The Adjustment of Global External Imbalances: Does Partial Exchange Rate Pass-Through to Trade Prices Matter?

45 Pages Posted: 24 Jan 2006

See all articles by Christopher Gust

Christopher Gust

Board of Governors of the Federal Reserve System

Nathan Sheets

Board of Governors of the Federal Reserve System

Date Written: February 2007

Abstract

This paper assesses whether partial exchange rate pass-through to trade prices has important implications for the prospective adjustment of global external imbalances. To address this question, we develop an open-economy DGE model in which firms set their prices with an eye toward maintaining their competitiveness against other producers; this feature of the model generates a variable desired markup and, hence, pass-through that is less than complete. With trade price elasticities of unity or greater, we find that for a given move in the exchange rate the nominal trade balance adjusts more when pass-through is high. However, an ofsetting consideration is that the exchange rate tends to be more sensitive to shocks in a low pass-through environment. We show that the relative importance of these considerations depends on the structural features of the economy, including the magnitude of the trade price elasticities and the sensitivity of private spending to shocks.

Keywords: Import prices, Export prices, Trade balance, Marshall-Lerner condition, DGE model

JEL Classification: F3, F41

Suggested Citation

Gust, Christopher and Sheets, Nathan, The Adjustment of Global External Imbalances: Does Partial Exchange Rate Pass-Through to Trade Prices Matter? (February 2007). FRB International Finance Discussion Paper No. 850r, Available at SSRN: https://ssrn.com/abstract=876602 or http://dx.doi.org/10.2139/ssrn.876602

Christopher Gust (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Nathan Sheets

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-3819 (Phone)
202-736-5638 (Fax)

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