Pricing to Market and the Real Exchange Rate


WP/95/12-EA
Pricing to Market and the Real Exchange Rate by Hamid Faruqee

Since the abandonment of fixed exchange rates in 1973, foreign exchange
markets have experienced a great deal of turbulence. However, the large
swings in exchange rates under the era of floating have not brought about
comparable variation in inflation or disinflation rates as one would expect
with pass-through. Instead, volatile nominal exchange rates have translated
into volatile real exchange rates in the post-Bretton Woods world, while
prices locally have remained remarkably stable.

In an attempt to understand these developments, this paper develops a
model of goods market segmentation wherein firms may systematically price
discriminate to stabilize prices and quantities across market destinations.
Motivated by a preponderance of empirical evidence disavowing the law of one
price, the model details some of the economic implications of pricing-to-
market behavior. Specifically, the framework examines some of the
macroeconomic consequences of market segmentation and shows the resulting
behavior of international prices to be broadly in line with the stylized
facts. The results include both cross-sectional implications regarding
nominal prices and time-series implications regarding relative prices.

Across different trade patterns, significant variation exists in the
degrees of pass-through and pricing to market depending upon the degree of
intraindustry trade and the substitutability between domestic and foreign
goods. Across time, dynamic adjustment in prices suggests that nominal and
real exchange rates move together over the short run and over the longer run
as well to the extent that markets remain segmented. Overall, pricing to
market provides a potentially important source of local price stickiness and
real exchange rate variability and persistence.