Price Setting and Exhange Rate Pass-Through

Abstract

There has been a considerable recent debate on the causes of low pass-through from exchange rates to consumer prices. This paper develops a simple model of a small open economy in which exchange rate pass-through is determined by the frequency of price changes of importing firms. But this, in turn, is determined by the monetary policy rule of the central bank. ¡¥Looser¡¦ monetary policy, which implies a higher mean inflation rate, and a higher volatility of the exchange rate, will lead to more frequent price changes and a higher rate of pass-through. The model implies that there should be a positive, but nonlinear, relationship between pass-through and mean inflation, and a positive relationship between passthrough and exchange rate volatility. In a sample of 122 countries, this is strongly supported by the data. Our conclusion is that, at least partly, low exchange rate pass-through is a result of short-term price rigidities.

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