Small price change response to a large devaluation in a menu cost model

Bruchez, Pierre-Alain (2007): Small price change response to a large devaluation in a menu cost model. Unpublished.

Abstract

In an empirical paper based on five large devaluation episodes in Argentina, Brazil, Korea, Mexico and Thailand, Burstein and al. (2005a) find a very slow adjustment in the prices of non-tradable goods and services after large devaluations. Burnstein and al. (2005b) develop a quantitative general-equilibrium model that can account for this phenomenon. I consider an alternative, simpler model and explore under which conditions moderate menu costs can explain the muted response of the prices of non-tradables. The key new element in this alternative model is a nominal friction in wage-setting (generated by menu costs for changing wages). I find, for example, that although my model is based on menu costs, it is able to deliver not only constant prices of non-tradables, but also small price changes (in reality these prices do change, albeit by far less than the exchange rate). I also discuss the existence of multiple equilibria and the role of central-bank credibility.

• Item Type: MPRA Paper
• Language: English
• Keywords: large devaluation; exchange rate; pass-through; sticky prices; sticky wages
• Subjects: F - International Economics > F3 - International Finance > F31 - Foreign Exchange

References

Burstein Ariel, Eichenbaum Martin and Sergio Rebelo (2005a), "Large Devaluations and the Real Exchange Rate," Journal of Political Economy, vol. 113(4), pages 742-784, August. Burstein Ariel, Eichenbaum Martin and Sergio Rebelo (2005b), "Modeling Exchange Rate Passthrough After Large Devaluations," Discussion Paper No. 5250, CEPR, September. Fishman Arthur and Avi Simhon, (2005) "Can Small Menu Costs Explain Sticky Prices?", Economics Letters 87(2), pages 227-230. Gonzales-Rozada Martín and Pablo Andres Neumeyer (2003), "The elasticity of substitution in demand for non-tradable goods in Latin America case study: Argentina," mimeo Universidad T. Di Tella. Huang Kevin and Zheng Liu (2002), "Staggered price-setting, staggered wage-setting and business cycle persistence," Journal of Monetary Economics 49, pages 405-433. Lorenzo Fernando, Aboal Diego and Rosa Osimani (2003),"The elasticity of substitution in demand for non-tradable goods in Uruguay," mimeo, Inter-American Development Bank Research Project. Midrigan Virgiliu (2006), "Menu Costs, Multi-Product Firms, and Aggregate Fluctuations," mimeo, January. Naknoi Kanda (2005), "Real exchange rate fluctuations, endogenous tradability and exchange rate regime," mimeo.