Macroeconomic Implications of Declines in Nominal Exchange Rate Pass-through Rates

Several studies have found that there have been declines in nominal exchange rate pass-through rates in recent years. In this paper we theoretically analyze the macroeconomic implications of such changes. A special feature of the analysis in the paper is that it builds a dynamic general equilibrium model that consists of two countries for this purpose. In the model there are two types of producers of tradable goods: those that set prices in their own currency and those that set prices in foreign currencies. The pass-through rate in this model is determined by the relative proportions of these two types. By conducting a simulation analysis using this model, we show how macroeconomic performance differs depending on the pass-through rate. Specifically, we derive the responses of prices of domestic import and export goods, inflation rates, GDP, and other indices in response to shocks such as fluctuations in exchange rates and changes in monetary policies in foreign countries, both in a high pass-through rate environment and in a low pass-through rate environment. This exercise reveals that reactions of an economy to external shocks depend in crucial ways on the degree of pass-through.