Person:

Gopinath, Gita

We survey the recent empirical and theoretical developments in the literature on the relation between prices and exchange rates. After updating some of the major findings in the empirical literature we present a simple framework to interpret this evidence. We review theoretical models that generate insensitivity of prices to exchange rate changes through variable markups, both under flexible prices and nominal rigidities, first in partial equilibrium and then in general equilibrium.

The closed and open economy literatures work on estimating real rigidities, but in parallel. We bring the two literatures together to shed light on this question. We use international price data and exchange rate shocks to evaluate the importance of real rigidities in price setting. We show that consistent with the presence of real rigidities the response of reset-price inflation to exchange rate shocks depicts significant persistence. Individual import prices, conditional on changing, respond to exchange rate shocks prior to the last price change. At the same time aggregate reset-price inflation for imports, like that for consumer prices, depicts little persistence. Competitors prices effect firm pricing and exchange rate pass-through into import prices are greater in response to trade-weighted as opposed to bilateral exchange rate changes. We quantitatively evaluate sticky price models (Calvo and menu cost) with variable markups at the wholesale level and constant markups at the retail level, consistent with empirical evidence. Variable markups alone generate sluggishness in price adjustment and increase the size of the contract multiplier, but their effects are modest.

We empirically document using U.S. import prices that on average goods with a high frequency of price adjustment have a long-run pass-through that is at least twice as high as that of low-frequency adjusters. We show theoretically that this relationship should follow because variable mark-ups that reduce long-run pass-through also reduces the curvature of the profit function when expressed as a function of the cost shocks, making the firm less willing to adjust its price. Lastly, we quantitatively evaluate a dynamic menu-cost model and show that the variable mark-up channel can generate significant variation in frequency, equivalent to 37% of the observed variation in the data. On the other hand the standard workhorse model with constant elasticity of demand and Calvo or state dependent pricing has difficulty matching the facts.

We propose a continuous time model to investigate the impact of inflation credibility on sovereign debt dynamics. At every point in time, an impatient government decides fiscal surplus and inflation, without commitment. Inflation is costly, but reduces the real value of outstanding nominal debt. In equilibrium, debt dynamics is the result of two opposing forces: (i) impatience and (ii) the desire to conquer low inflation. A large increase in inflation credibility can trigger a process of debt accumulation. This rationalizes the sovereign debt booms that are often experienced by low inflation credibility countries upon joining a currency union.

We empirically characterize the mechanics of trade adjustment during the Argentine crisis. Though imports collapsed by 70 percent from 2000-2002, the entry and exit of firms or products at the country level played a small role. The within-firm churning of imported inputs, however, played a sizeable role. We build a model of trade in intermediate inputs with heterogeneous firms, fixed import costs, and roundabout production. Import demand is non-homothetic and the implications of an import price shock depend on the full distribution of firm-level adjustments. An import price shock generates a significant decline in productivity.

We show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a dynamic New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions—producer or local currency pricing, along with nominal wage stickiness; under arbitrary degrees of asset market completeness and for general stochastic sequences of devaluations. There are two types of fiscal policies equivalent to an exchange rate devaluation—one, a uniform increase in import tariff and export subsidy, and two, a value-added tax increase and a uniform payroll tax reduction. When the devaluations are anticipated, these policies need to be supplemented with a consumption tax reduction and an income tax increase. These policies are revenue neutral. In certain cases equivalence requires, in addition, a partial default on foreign bond holders. We discuss the issues of implementation of these policies, in particular, under the circumstances of a currency union.

We characterize fiscal and monetary policy in a monetary union with the potential for rollover crises in sovereign debt markets. Member-country fiscal authorities lack commitment to repay their debt and choose fiscal policy independently. A common monetary authority chooses inflation for the union, also without commitment.  We first describe the existence of a fiscal externality that arises in the presence of limited commitment and leads countries to over borrow; this externality rationalizes the imposition of debt ceilings in a monetary union. We then investigate the impact of the composition of debt in a monetary union, that is the fraction of high-debt versus low-debt members, on the occurrence of self-fulfilling debt crises. We demonstrate that a high-debt country may be less vulnerable to crises and have higher welfare when it belongs to a union with an intermediate mix of high- and low-debt members, than one where all other members are low-debt. This contrasts with the conventional wisdom that all countries should prefer a union with low-debt members, as such a union can credibly deliver low inflation. These findings shed new light on the criteria for an optimal currency area in the presence of rollover crises.

We document the behavior of trade prices during the Great Trade Collapse of 2008- 2009 using transaction-level data from the U.S. Bureau of Labor Statistics. First, we find that differentiated manufactures exhibited marked stability in their trade prices during the large decline in their trade volumes. Prices of non-differentiated manufactures, by contrast, declined sharply. Second, while the trade collapse was much steeper among differentiated durable manufacturers than among non-durables, prices in both categories barely changed. Third, the frequency and magnitude of price adjustments at the product level changed with the onset of the crisis, consistent with a state-dependent view of price adjustment. The quantitative magnitudes of the changes, however, were not pronounced enough to affect aggregate prices. Our findings present a challenge for theories of the trade collapse based on cost shocks specific to traded goods that work through prices.

Relative cross-border retail prices, in a common currency, comoves closely with the nominal exchange rate. Using a data set with product level retail prices and wholesale costs for a large grocery chain operating in the U.S. and Canada, we decompose this variation into relative wholesale costs and relative markup components. We find that the correlation of the nominal exchange rate with the real exchange rate is mainly driven by changes in relative wholesale costs, arguably the most tradable component of a retailer’s costs. We then measure the extent to which national borders impose additional costs that segment markets across countries. We show that retail prices respond to changes in wholesale costs in neighboring stores within the same country but not to changes in wholesale costs in a neighboring store located across the border. In addition, we find a median discontinuous change in retail and wholesale prices of 24 percent at the international border. By contrast, the median discontinuity is 0 percent for state and provincial boundaries.

Emerging markets in the 1990s experienced periods of booms followed by collapses in gross domestic product, consumption, traded and non-traded sector output and real exchange rate movements alongside unprecedented movements in foreign investor participation in these economies. An important feature of these episodes is the asymmetry in the pattern of booms and collapses. We introduce a natural search friction into the foreign investment decision in a small open economy and demonstrate that this can generate the asymmetry observed in the data. The magnitude of the reversals predicted by the model can be quantitatively large and empirically relevant.