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Board of Governors of the Federal Reserve System (U.S.)
International Finance Discussion Papers
The Adjustment of Global External Imbalances: Does Partial Exchange Rate Pass-Through to Trade Prices Matter?
Christopher J. Gust
Nathan Sheets
Abstract

This paper assesses whether partial exchange rate pass-through to trade prices has important implications for the prospective adjustment of global external imbalances. To address this question, we develop an open-economy DGE model in which firms set their prices with an eye toward maintaining their competitiveness against other producers; this feature of the model generates a variable desired markup and, hence, pass-through that is less than complete. With trade price elasticities of unity or greater, we find that for a given move in the exchange rate the nominal trade balance adjusts more when pass-through is high. However, an offsetting consideration is that the exchange rate tends to be more sensitive to shocks in a low pass-through environment. We show that the relative importance of these considerations depends on the structural features of the economy, including the magnitude of the trade price elasticities and the sensitivity of private spending to shocks.


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Christopher J. Gust & Nathan Sheets, The Adjustment of Global External Imbalances: Does Partial Exchange Rate Pass-Through to Trade Prices Matter?, Board of Governors of the Federal Reserve System (U.S.), International Finance Discussion Papers 850, Jan 2006, revised Feb 2007.
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Keywords: Import prices; Export prices; Trade balance; Marshall-Lerner condition; DGE model
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