ABSTRACT
Since the fall of the Bretton Woods system, nominal and real exchange rate fluctuations exhibit large and persistent departures from purchasing power parity. The Betts and Devereux’s (1996) interpretation of this phenomenon relies on the failure of the law of one price among internationally traded goods. Firms tend to set prices in the buyer’s currency (pricing-to-market, PTM) and do not adjust prices to changes in the nominal exchange rate. As a consequence, following a money expansion, the money market equilibrium requires an increase in the consumption price level. With sticky-product prices and PTM, nominal exchange rate hardly affects import prices. For a given change in relative money supplies, a larger nominal exchange rate depreciation is needed to clear the money market. As a result, PTM magnifies exchange rate responses to monetary shocks. Chari et al. (2002) assess the empirical relevance of this mechanism by embedding PTM into a general equilibrium dynamic model. Chari et al. (2002) find that PTM behavior generates deviation from the law of one price whose volatility is somewhat consistent with the data. Betts and Devereux’s (1996) explanation of exchange rate volatility is based
on the behavior of traded good prices. In contrast, according to Hau (2000), large nominal exchange rate fluctuations are attributable to the presence of non-traded goods. The more closed the economy, the larger the exchange rate fluctuations. Indeed, when the law of one price holds, non-tradables reduce the impact of import prices on the consumer price level. The money market equilibrium requires a larger exchange rate depreciation following the expansion in the money supply. The literature tends to discard this explanation to exchange rate fluctuations since Chari et al. (2002) and Engel (1999) assert that the relative price of non-traded goods play no role in accounting for real exchange rate fluctuations. However, the non-tradable sector represents a sizeable part of any industrial
country. Besides, taking into account the presence of non-traded goods, as suggested by Hau (2000), it may actually mitigate the impact of PTM on exchange rates through the effect of non-tradables on consumer price indices. This chapter therefore proposes a unified theoretical framework including PTM behavior and non-tradables in a two-country sticky-price model. The purpose of this work
is twofold. First, we shed light on the way PTM and non-tradables interact in the exchange rate determination. It is shown that, on the one hand, since PTM affects the behavior of tradable prices, local currency pricing matters especially when the share of tradables is not negligible, that is, the economy is open. On the other hand, the degree of openness does not matter if import prices do not respond to exchange rate changes because of PTM behavior. Second, the model could help us determine which effect is likely to be the key ingredient in the understanding of the high exchange rate volatility. Is PTM, more than nontradables, responsible for the extreme exchange rate variability observed since the fall of the Bretton Woods system? This chapter is an attempt to answer this question. Section 4.2 presents the model. Section 4.3 deals with the exchange rate deter-
mination in this framework while Section 4.4 provides a quantitative discussion of the results. Section 4.5 concludes.
