Milton Friedman advocated flexible exchange rates on the premise that they would allow the relative prices of domestic and foreign goods to adjust in a world with nominal rigidities. The strength of his argument, and its implications for monetary and exchange rate policy, depend crucially on the specifics of nominal rigidity: How rigid are prices? Are prices fixed in the producer's currency or in the local currency? When prices adjust, how much do they respond to exchange rate shocks?
The validity of several of the benchmark models and the main hypothesis in international macroeconomics--such as the Mundell-Fleming models of the 1 960s, Dornbusch's overshooting exchange rate hypothesis, and the more recent New Open Economy Macroeconomics literature--also depend on the answers to these questions. In a series of papers, my coauthors and I shed light on these questions by providing evidence for actual traded goods prices. Using micro-data on US. import and export prices at-the-dock for the period 1994 to 2009, we develop theoretical models that provide a better fit for the empirical evidence than earlier theoretical environments.
Nominal and Real Rigidities in Traded Goods Prices
Significant nominal and real rigidities (1) in the pricing of traded goods are shown in my work with Roberto Rigobon. (2) The median price duration in the currency of pricing is long at 10.6 (12.8) months for U.S. imports (exports). Also, 90 percent (97 percent) of imports (exports) are priced in dollars. In international macro models it is typically assumed that prices are either all rigid in the local currency (importer's currency) or in the producer's currency (exporter's currency), and this assumption is symmetric across countries. In the case of the United States, contrary to this assumption, we find local-currency pricing for imports and producer-currency pricing for exports. This suggests an asymmetry in terms of which country bears the costs/benefits of exchange rate movements. Given the long durations between price adjustment and with most goods prices sticky in dollars, the pass-through of exchange rate shocks into import prices is low in the short run. Interestingly though, even conditioning on a price change, bilateral exchange rate pass-through into U.S. import prices is low, at 22 percent. We further document that differentiated goods manufactures exhibited marked stability in their trade prices during the Great Trade Collapse of 2008-9, despite the large decline in their trade volumes. (3)
The fact that the vast majority of import prices into the United States are rigid in dollars for a significant duration and that, even conditional on a price change, the response of dollar prices to exchange rate shocks is limited, implies that exchange rate movements produce between zero and small relative price effects over short-and medium-run horizons. This seriously limits the quantitative importance of the Friedman mechanism for the United States.
Currency of Pricing and Pass-Through
The broader question of optimality of a floating-versus-a-pegged exchange rate has been researched extensively in open economy macroeconomics. The presence of nominal rigidities in price setting generates trade-offs between the two exchange rate regimes. In a large class of models used to evaluate optimal policy, the currency of pricing is assumed to be exogenously chosen. In the short run when prices are rigid, there is a 100 percent pass-through into import prices of goods priced in the producer's currency and a zero percent pass-through for goods priced in the local currency. When prices adjust, there is no difference in pass-through. Exogenous currency choice results in stark outcomes, like the optimality of floating exchange rates under producer-currency pricing which ensures expenditure switching, and pegging under local-currency pricing which preserves the law of one price. A fundamental question then follows: is pass-through unrelated to the currency of pricing when prices adjust? …