Exchange Rate Volatility, Pricing to Market and Trade Smoothing

WP/97/126-EAWP/97/126


.Exchange Rate Volatility, Pricing to Market and Trade Smoothing.
by Peter B. Clark and Hamid Faruqee


Since the breakdown of the Bretton Woods fixed exchange rate system in 1973,
there has been a substantial increase in nominal and real exchange rate
volatility, with little adverse effect on the level of international trade. To
understand why the prices and quantities of traded goods may be relatively
insulated from short-term variations in exchange rates, this paper develops a
model of pricing-to-market behavior based on the assumption of market
segmentation, where economic forces and structural rigidities limit convergence
in the prices of the same goods across different markets, so the law of one
price does not hold.


The paper develops a two-country model of monopolistic competitors who set
prices for their differentiated products and choose production levels depending
on the demand for their individual products. The analysis focuses on the
consequences of pricing to market for the degree of pass-through of exchange
rate changes on the levels and variances of export prices and quantities. It
finds that this pass-through, which depends importantly on the convexity of
costs and the openness of the economy, is incomplete and that unpredictable
movements in exchange rates have a relatively small effect in raising the level
of export prices and thereby in reducing the volume of international trade.


The paper provides some illustrative empirical estimates of the variance
pass-through, i.e., the extent to which the variance of the exchange rate is
reflected in the variance of import prices, using aggregate price data for the
G-7 countries and industry-specific data for the United States. The variance
pass-through is incomplete except in industries with homogenous products where
pricing to market is unlikely to hold. Overall, the theoretical implications of
pricing-to-market behavior, as well as the illustrative empirical results,
suggest that the substantial short-run volatility of nominal exchange rates
over the last 25 years has not adversely affected economic performance.