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

48 Pages Posted: 20 Feb 2006

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Luca Dedola

Bank of Italy; European Central Bank (ECB)

Sylvain Leduc

Federal Reserve Banks - Federal Reserve Bank of San Francisco

Multiple version iconThere are 2 versions of this paper

Date Written: December 2005

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.

Keywords: International business cycle, exchange rate volatility, pass-through, international transmission, DSGE models

JEL Classification: F33, F41

Suggested Citation

Corsetti, Giancarlo and Dedola, Luca and Leduc, Sylvain, DSGE Models of High Exchange-Rate Volatility and Low Pass-Through (December 2005). CEPR Discussion Paper No. 5377, Available at SSRN: https://ssrn.com/abstract=885963

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR)

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Luca Dedola

Bank of Italy ( email )

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European Central Bank (ECB) ( email )

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Sylvain Leduc

Federal Reserve Banks - Federal Reserve Bank of San Francisco ( email )

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San Francisco, CA 94105
United States

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