Exchange-rate fluctuations and pass-through

It is well known that prices respond only partially, if at all, to changes in the nominal exchange rate. Exchange-rate pass-through, quite low for consumer prices, is far for complete for international prices as well (see the survey in Goldberg and Knetter [1997]). To the extent that incomplete exchange rate pass-through is due to destination specific markup adustment by firms, this is evidence of price discrimination. In turn, price discrimination implies that high exchange rate volatility will drive systematically apart cross-borders prices of otherwise identical goods. This paper develops a quantitative, dynamic open-economy model of endogenous incomplete pass-through and price discrimination. Building on Corsetti and Dedola [2003], upstream firms with monopoly power optimally charge different prices to competitive retailers situated in different locations. What makes the elasticity of demand differ across marekts is the requirement for local-input-intensive distribution services. Therefore, deviations from the law of one price for both wholesale and retail prices derive endogenously from optimal pricing by monopolistic firms. Moreover, exchange-rate pass-through is incomplete -- its degree depending on the type and persistence of the shocks hitting the economy. This makes an assessment of the general equilibrium movements in consumer prices associated with exchange-rate fluctuations by no means trivial. Therefore, we calibrate our model to U.S. and European data and use it to quantify the general equilibrium effects of the differential impact of real and monetary shocks on exchange rates and prices. We also evaluate the distinctive role of wages and price rigidities in allowing the model to match the data. This is important because we can distinguish the contribution to a low degree of pass-through stemming from the endogenous price discrimination channel on the one hand, and that arising as an implication of price rigidities, under the assumption that foreign exporters face frictions in adjusting prices in local currencies