MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rates and Adjustment:
Perspectives from the New
Open-Economy Macroeconomics
Keynote Speech by Maurice Obstfeld

The new open-economy macroeconomics has allowed economists totackle classical problems with new tools, while also generating new
ideas and questions. In their attempts to make the new models
capture empirical regularities, researchers have entertained a varietyof assumptions about the international pricing of goods, notably,models of pricing to market and destination-currency pricing ofexports. Some of the resulting models imply that exchange ratechanges lack international expenditure-switching effects, and they
thus appear to call for a radical rethinking of the role of exchange
rates in international adjustment. This paper argues that the recent
resurgence of exchange rate pessimism stems from oversimplified
modeling strategies rather than from evidence. Like earlier episodes
starting with the extreme “elasticity pessimism” of the early postwar
era, it is based on a misinterpretation of the empirical record.
Key words: Exchange rate policy; International adjustment;
Expenditure-switching effects; Elasticity pessimism;
International competitiveness

University of California, Berkeley (E-mail: obstfeld@econ.berkeley.edu)
Julian di Giovanni provided expert research assistance. I am grateful for a discussion with
Giancarlo Corsetti. All errors and opinions are mine. Support from the National Science
Foundation of the United States, through a grant to the National Bureau of Economic
Research, is acknowledged with thanks.

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I. Introduction
Recent research on open-economy macroeconomics has produced a synthesis ofdynamic intertemporal approaches with older sticky-price models of macroeconomic
fluctuations. This synthesis, which has become known as the new open-economy
macroeconomics, has allowed economists to tackle classical problems with new tools,
while also generating new ideas and questions. The presence of a foundation in
microeconomic optimization allows a rigorous welfare analysis of policies andregimes. The approach also invites a rich analysis of alternative product, labor, andasset-market structures.
In their attempts to make these models capture empirical regularities moreaccurately, researchers have entertained a variety of assumptions regarding the
behavior of international prices. Some of these models appear to call for a radical
rethinking of conventional views on the role of exchange rates in international adjustment.1 It is a good illustration of the power of the new approach, but also a matterof vast consequence for policy analysis, to reconsider the stabilization benefits of
exchange rate flexibility. Pessimism over the gross benefits of flexible exchange rates
is a perennial feature of the intellectual landscape, and the newest bout is based on
the observation of extremely low and slow pass-through of exchange rate changes to
consumer prices. I argue below that the recent resurgence of exchange rate pessimism
stems from oversimplified modeling strategies rather than from evidence. Like earlier
episodes starting with the extreme “elasticity pessimism” of the early postwar era, it isbased on a misinterpretation of the empirical record. In reality, the case that exchange
rates are an aid in international adjustment remains strong—at least for now.

II. Five Varieties of Exchange Rate Pessimism
Do exchange rate changes promote international adjustment? The question is an
old one; so old, indeed, that its meaning has evolved substantially over the years.
When the Bretton Woods institutions began operating in the late 1940s, the term
“international adjustment” was widely understood in terms of restoring equilibriumin the balance of payments. Exchange depreciation, say, would reduce a payments
deficit if its effects on international relative prices led to sufficiently higher export
and lower import levels. Nowadays, one might ask instead whether exchange ratevariation is an essential implication of welfare-maximizing policy feedback rules. But
the basic implication for the currency regime of a negative answer has not changed. If
exchange rate changes play no beneficial role—by cushioning the effects of shocks oninternational payments or aggregate activity—then a credible fixed exchange rate
regime such as a currency union is preferred to one entailing variable exchange rates.
In light of the persistence of debate over the optimal currency regime, it is no surprisethat the potential inefficacy of exchange rate changes has been a constant theme inthe literature. That theme, however, has had many variations that are sometimes
1. For an excellent survey taking a more formally analytic approach than this one, see Engel (2002). See also
Duarte (2001).

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Exchange Rates and Adjustment: Perspectives from the New Open-Economy Macroeconomics

overlapping but sometimes mutually inconsistent. A review of these many variations
is useful, however, as it provides a capsule history of thought that serves to put
current debates into perspective.2
A. Variation 1: Classic Elasticity Pessimism
Starting with studies by Tinbergen in the mid-1930s (Tinbergen [1937]), empiricalresearchers of the pre- and early post-World War II era formed the view that priceelasticities in export and import demand were quite low—too low, for example, tosatisfy the classic Marshall-Lerner condition under which a currency depreciation will
improve the trade balance. Thus, Metzler (1948, p. 232) concluded:
Considering the low price elasticities which have been found in most empiricalstudies of demand, it seems probable that depreciation, in the short run,cannot improve a country’s trade balance unless the inelastic demand for imports
is matched by a corresponding inelastic supply of exports. Even in this case theelasticity of the trade balance will probably be small, and a substantial movementof exchange rates may therefore be required to eliminate rather modest deficits. In
other words, over comparatively short periods of time, movements of exchange
rates are not an efficient means of allocating resources between foreign anddomestic use.
Metzler went on to argue that these conclusions rationalized the Bretton Woods
emphasis on exchange stability as well as the use of direct import controls, though healso suggested that trade elasticities are higher in the long run, justifying currency
realignment (notwithstanding short-run negative effects on the trade balance) insituations of fundamental disequilibrium.
A famous paper by Orcutt (1950), written at the International Monetary Fund’s(IMF’s) research department (see Blejer et al. [1995]), showed how aggregation bias,
simultaneity bias, lags, and other factors could lead a naive econometrician to find
low trade elasticities even when elasticities were reasonably high. See also Machlup(1950), who apparently coined the phrase “elasticity pessimism.” Subsequent research,
including work on disaggregated data, suggests that trade elasticities really are higher
over an annual horizon than the earliest statistical studies suggested. For reasons that
I will take up in a later section, the elasticities are no doubt significantly higher today
than they were at the start of the floating-rate period.
B. Variation 2: Purchasing Power Parity (PPP) Models
A very different argument leading to the prescription of fixed exchange rates grows
out of the modeling tradition associated with the monetary approaches to the balanceof payments and exchange rates. In such frameworks, money prices adjust flexibly to
2. Below, I restrict the discussion, perhaps somewhat artificially, to pessimistic assessments of the direct (and partial)
effects of exchange rate changes on relative international prices and demands, holding income and wealth levels
constant. Thus, I am ignoring the fact that exchange rate changes can have collateral contractionary effects, forexample, through balance sheets, that could nullify or reverse any potential expansionary effect due to expenditureswitching among countries. In this paper, the question is whether the partial expenditure-switching effects
themselves are substantially positive over a relevant horizon.

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clear markets and the law of one price holds for tradables. In this world, money isneutral and nominal exchange rate changes play no central allocative role. A variantof this class of model holds that while countries may produce different outputs,
substitution elasticities are so high that we can aggregate all countries’ outputs into asingle good—an extreme form of elasticity optimism. In a sense, elasticities are toohigh rather than too low ! In such a world, exchange rate adjustments cannot affectrelative international prices. McKinnon (1984), for example, advocated fixedexchange rates coupled with “world monetarism” based on this type of model.
Krugman (1991) has made an effective case against the approach.
A variant of this argument is applied to developing countries; see, e.g., Calvo andReinhart (2002). It is held that for many developing countries, pass-through to thegeneral consumer price index (CPI) is so rapid as to reduce greatly the stabilizing
benefits of flexible exchange rates.
C. Variation 3: Real Wage Rigidity
In the late 1970s, economists argued that whereas U.S. labor markets were characterized by nominal wage rigidity, labor markets in Europe seemed to be beset by real
wage rigidity, one symptom of alleged “eurosclerosis.” Branson and Rotemberg(1980) and Sachs (1980) provided Mundell-Fleming style models of macroeconomic
policy under real wage rigidity, models with the implication that monetary policy
would be ineffective under a floating exchange rate.
Assume that output supply is a function of a variable labor input and a fixed
capital input, with firms’ labor demand a decreasing function of the real productwage. On the other hand, union wage demands result in a constant real CPI wage.
Demand for domestic output is a declining function of the real exchange rate definedin terms of the domestic output price, which itself is flexible and equates supply todemand. As is standard in the Mundell-Fleming model, import prices are given interms of foreign currency and adjust one-for-one with the exchange rate.
The result that monetary expansion is ineffective then follows. By raising importprices and hence the domestic CPI, a currency depreciation sparks higher nominal
wage demands. The resulting incipient rise in the product wage would induce
reduced supply by firms, so there is upward pressure on the domestic good’s priceand hence further upward pressure on the nominal wage. Equilibrium is restored
when the nominal output price, nominal wage, and exchange rate have all risen inproportion to the monetary expansion, leaving the real wage, real exchange rate, andreal domestic output unperturbed. In short, the nominal wage rise nullifies any
employment-expanding effect of a monetary expansion. Interestingly, the argument
follows regardless of the size of the import share in domestic consumption.3
In the 1990s, the alleged rigidity of real wages in Europe provided one of thearguments for proceeding to a single currency. European labor markets, it wasargued, rendered monetary policy fairly ineffective anyway, so the cost of giving up
national monetary policy levers would be low. In Obstfeld (1997), I discuss this
3. Fiscal expansion, in contrast, can be effective in raising output and employment. Because the domestic currency
appreciates in order to crowd out foreign demand, the real wage measured in terms of product prices has room todecline even though the real wage in terms of consumer prices remains constant.

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Exchange Rates and Adjustment: Perspectives from the New Open-Economy Macroeconomics

argument in further detail and suggest that in the runup to the euro, there were stillgood reasons to attach gross costs to the surrender of national monetary autonomy.
One should note also that the argument of real wage rigidity would apply to Europe
as a whole, so that we might infer from simple models of rigid real wages that theEuropean Central Bank’s monetary policy can be effective only through large-country
effects. In practice, things have worked differently. In aggregate, the euro zone is lessopen than are the individual economies of its members, output prices are sticky, andthe euro’s steep depreciation after its launch did not induce anything close to a corresponding inflation in output prices. Moreover, most observers would judge the euro’sslide to have allowed stronger European growth than would otherwise have occurred.
D. Variation 4: Pricing to Market and Sunk Costs
As the dollar depreciated from the heights attained in 1985, the U.S. current accountdeficit initially behaved perversely, widening for about two years before improving
in a manner more consistent with standard theory. While economists subsequently
concluded that nothing had really been amiss—see Krugman (1991) for further
discussion—the 1985–87 experience nonetheless generated a spate of nonstandard
theorizing that has enriched our view of the international adjustment process and ofinternational price behavior.
In a seminal contribution, Dornbusch (1987) showed how strategic interactions
among domestic producers and competing producers of imports could result in a
muted response of import prices to exchange rate changes, at least compared to thefull proportional response predicted by the Mundell-Fleming model’s small countrycum-law of one price assumption. When markets are internationally segmented—
so that resale arbitrage is limited—producers of tradable goods may gain the ability
to practice third-degree price discrimination, tailoring the prices they charge toindividual market destinations. Under such pricing-to-market (PTM), a Japanese
exporter to the United States, faced with a yen appreciation against the dollar, might
not raise the export’s dollar price pro tanto. Instead, it might choose to lower the yen
price and thereby reduce its profit margin on U.S. sales so as to defend its U.S. market
share. In this scenario, the good’s dollar price for Americans rises by less than thedollar’s depreciation against the yen. The depreciation’s effect on the relative price ofJapanese imports and competing U.S. goods is thereby dampened. Empirical studies
have convincingly demonstrated the prevalence of PTM behavior in manufacturing
trade among Organisation for Economic Co-operation and Development (OECD)
countries; see Goldberg and Knetter (1997). A stylized fact of this literature is that in
response to a 10 percent depreciation of a target country’s currency, exporters lower theexport’s own-currency price by around 5 percent in the same year. That is, the medianpass-through of currency depreciation to manufacturing import prices tends to bearound 50 percent over a one-year horizon.
It is important to keep in mind at this point the distinction between pass-throughof exchange rate changes to import prices and pass-through to domestic importcompeting goods’ prices and the overall CPI. Other things equal, more extensive andrapid pass-through to import prices will enhance the expenditure-switching effects ofan exchange rate change. In contrast, fuller and faster pass-through to domestic prices

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will reduce the expenditure-switching effects. Indeed, in the PPP model discussed as
Variation 2 above, rapid pass-through to the entire range of goods in the CPI nullifies
the exchange rate’s potential expenditure-switching role. Why might we expect rapid
pass-through to import prices but slow pass-through to the CPI in response to amonetary shock? Because wage costs are a major component in production, andwages are both nominally sticky and (in normal conditions) very sluggish. Given thissluggishness in domestic-currency costs, output prices will inherit a tendency torespond sluggishly to monetary impulses, whereas exporters will face corresponding
pressures to maintain the domestic-currency prices of their exports so as to maintainprofit margins. Indeed, dynamic studies such as Campa and Goldberg (2001)
suggest substantially complete long-run pass-through of exchange rate changes toimport prices.
If PTM and partial pass-through are short-term phenomena, they can have only
limited power to explain delayed adjustment to exchange rate changes. A second
but related theoretical innovation of the late 1980s goes further in this regard. The
literature on sunk costs and hysteresis in trade (for example, Baldwin and Krugman[1989] and Dixit [1989]) predicts that a large exchange rate change’s trade effects will
not be reversed merely by the unwinding of the exchange rate change. If exporting
firms have incurred sunk costs to establish “beachheads” in the target country, aneven larger exchange rate reversal may be needed before these firms reduce export
supply and fully raise export prices. Once again, relative prices and trade flows may
become less responsive to the exchange rate over some range. Such hysteretic effects,
though doubtless present in reality, seem to have little bearing on the broad patternsof adjustment occasioned by large, persistent exchange rate swings.
The point to take home is that the theoretical advances of the late 1980s modify
our view of the short-term adjustment to exchange rate changes, but leave prettymuch intact our assessments of the longer-term effects on the current account of
permanent changes in monetary policy.
E. Variation 5: PTM with Local Currency Pricing
The literature on the new open-economy macroeconomics has allowed modelers
to assess the implications of several forms of price and wage rigidity within fully
specified dynamic general-equilibrium models. In open economies, nominal pricerigidities can take various forms, and differences in pricing patterns can induce
sharp alterations both in patterns of macroeconomic adjustment and in the welfare
properties of monetary regimes.
One strand in the literature takes as its empirical starting point the finding thatfor CPI real exchange rates, the tradable/nontradable distinction seems to carry little
explanatory power: at least when nominal exchange rates are highly variable, relativeinternational tradables prices move pretty much in line with relative international
nontradables prices (Engel [1999]). One possible interpretation of this result is thatexporters not only price-discriminate across markets, they also preset export prices
in the buyer’s currency and meet demand at the posted local-currency prices inthe short run. With domestic prices also preset in the home currency, real CPI
exchange rates and nominal exchange rates will be nearly perfectly correlated in the

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Exchange Rates and Adjustment: Perspectives from the New Open-Economy Macroeconomics

short run, as we indeed see in data from moderate-inflation countries. Chari et al.
(2000) and Devereux and Engel (2000), among others, have explored models inwhich exporters effectively sell directly to consumers on the basis of PTM and local
currency pricing (LCP).
LCP by exporters has important implications for the economy’s adjustment
to an exchange rate change. Suppose that a monetary expansion induces a currency
depreciation. With import as well as domestic prices sticky, the currency change
cannot switch domestic demand from imports to domestic goods. The main domestic
economic effects will be on the profits of home exporters. If they price their goods inforeign currency, the depreciation of the home currency raises their profits measured indomestic-currency terms.
In the case of LCP we have exchange rate pessimism, not because elasticities ofsubstitution between imports and domestic substitutes are small, but because theresponses of import prices to exchange rates are assumed to be nil. In the next section,
I take up some of the policy implications of this view. I then explore alternativemodels that respect the empirical regularities stressed by Engel (1999), yet incorporatea significant expenditure-switching role for exchange rates.

III. Local Currency Pricing and Its Implications
New open-economy macro models with and without LCP can have strikingly
different welfare implications. In this section, I discuss the policy and empiricalimplications of some alternative models.
A. Pricing in Buyer Currency: Simple Models
Some models in the new open-economy macroeconomics assume that import prices
are sticky in producer currency—the case of producer currency pricing (PCP). In
principle such a formulation, coupled with some international market segmentation,
could be consistent with PTM by exporters, who might set different producercurrency prices for goods destined for different markets. Such an approach would
nonetheless imply a unitary short-run elasticity of import prices with respect to theexchange rate, so most models take the simpler tack of assuming the law of one pricefor imported goods, as in the Mundell-Fleming model.
Obstfeld and Rogoff (2000) develop a sticky-wage model along these lines andexplore its implications for optimal monetary policy rules in the face of exogenous
productivity shocks. In that model, there are monopolistic distortions in labor andproduct markets, but monetary rules cannot offset these to raise welfare above its
flexible-wage level. The best that monetary policy can do is to achieve the flexiblewage allocation associated with the realized values of the productivity shocks, whichis constrained-efficient—that is, efficient subject to the monopoly distortions. (Thisresult turns out to hold true not only when international policymakers cooperatein choosing their rules, but also in a Nash equilibrium.) In the flexible-wageequilibrium, a negative home relative productivity shock (holding world average
productivity constant) would require a fall in relative home output and a rise in its

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relative price. A home monetary contraction and an equal foreign expansion appreciate the home currency, raising the price of home output to foreigners and lowering
the foreign-output price to home residents due to the PCP assumption. Thus, freely
variable exchange rates support the constrained-optimal flexible-wage allocation evenwhen wages are preset and sticky ex post.
These results must be modified when there are additional distortions in the world
economy, as Obstfeld and Rogoff (2002) show. If the flexible-wage allocation is notconstrained-efficient, it becomes possible for monetary rules to improve upon it if
those rules are geared partially toward the extra distortions. In Obstfeld and Rogoff ’s(2000) model, international consumption risk sharing is perfect; the authors’ 2002
paper allows for imperfect international risk sharing, which introduces an additional
distortion alongside the sticky-wage distortion. Now, in a global cooperative equilibrium, optimal monetary rules no longer strive to replicate the flexible-wage
allocation ex post. Instead, such rules depart from the latter allocation in order toimprove international risk-sharing, and, depending on preference parameters,
exchange rates can be more or less variable than under the flexible-wage rules. (It is nolonger the case, either, that cooperative and Nash rules coincide.) Goodfriend andKing (2001) characterize monetary rules that replicate flexible-price equilibria ex post
as delivering “price stability.” Using their terminology, we might say that in thesemodels, optimal monetary policy aims to produce nominal wage stability (rather thanexchange rate stability) when wage rigidity is the only relevant distortion. Otherwise,
there can be a trade-off between wage stability and other economic objectives. Benigno
and Benigno (2001) illustrate other departures from price-stabilizing optimal policies
under PCP and full arbitrage of markets for tradable goods.4
The model in Devereux and Engel (2000) departs from the preceding ones byassuming that exporters can price-discriminate across home and foreign markets(PTM), and that they preset prices in the currency of the buyer (LCP). They also
assume complete markets in contingent nominal payments. The model easily
captures the regularity that movements in nominal and real CPI exchange rates
are tightly correlated, because every country’s CPI is preset in its entirety, both
the domestic and imported components. Another realistic implication is that there
are deviations from the law of one price for tradables, deviations that are highly
correlated with changes in nominal exchange rates. As in the preceding models,
however, Devereux and Engel (2000) do not distinguish between the consumer prices
of imported goods and the producer prices at which manufacturers of the imports
sell their wares to domestic retailers. Thus, in the aggregate, every country faces
temporarily rigid relative prices of domestic output in terms of imports.
If countries’ imports are priced in local currencies, the implications for optimalmonetary policies are drastic. First, exchange rate changes become powerless to alter
the relative prices that domestic economic agents face. Thus, the important allocativerole of flexible exchange rates in PCP models evaporates. Monetary policy simply
4. When each country has a multisector structure and shocks between domestic sectors are important, an exchange
rate change, while efficient for handling purely country-specific shocks, can no longer guarantee the correct
relative prices between domestic sectors. In this case of more targets than instruments, the value of exchange rate
flexibility may again be reduced. For a full discussion, see Tille (2002).

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Exchange Rates and Adjustment: Perspectives from the New Open-Economy Macroeconomics

cannot be used in general to attain the flexible-price allocation ex post. The exchange
rate has no expenditure-switching power, so exchange rate pessimism is justified.
What role is there, then, for ex post exchange rate flexibility? The perhaps surprising answer is: possibly none. As Engel (2002) stresses, the model’s complete nominalbond markets assumption makes international relative intertemporal marginal rates
of substitution proportional to real exchange rate changes. To minimize ex post
departures from true risk sharing (the complete risk sharing that a global planner
could achieve if he or she could circumvent the barriers segmenting the two countries’ goods markets), real exchange rate fluctuations should be minimized. There isno trade-off between risk sharing and domestic stabilization, unlike in Obstfeld andRogoff (2002), because the exchange rate is powerless to change the relative pricesthat economic actors face. Thus, welfare may be maximized when the nominal
exchange rate is fixed.
More complex issues can arise when, unlike in Devereux and Engel’s (2000) model,
the disutility of labor effort is a strictly convex (rather than linear) function. In thatcase, there is a trade-off between global efficiency and exchange rate stability, sincedifferential monetary stances can help to keep national marginal disutilities of labor
effort in line with national productivity levels. I have been assuming until now thatnational monetary rules respond exclusively to productivity shocks, but if there isexogenous variability in foreign monetary policy, say, it may pay for the home country
to adopt a flexible exchange rate so as to insulate itself from external inflationary shocks.
The important message of this literature, however, is that the LCP model appears
to deliver a stronger case for exchange-rate oriented monetary rules than do models
assuming PCP, which instead suggest “benign neglect” of foreign exchange markets.5
Corsetti and Pesenti (2001) delve further into these questions. In their twocountry model, producers sell domestic goods in home as well as foreign markets andpotentially can practice price discrimination across borders. Specifically, the degree ofpass-through of the exchange rate to export prices is indexed by a parameter η, suchthat η = 0 corresponds to LCP and η = 1 to PCP. Markets are incomplete (onlynoncontingent bonds are traded between countries), but the model’s equilibrium
implies that nominal consumption spending always equals nominal national revenue(so that current accounts are always zero). When η = 1, the model is isomorphic toa dynamic version of the one in Obstfeld and Rogoff (2000) (without any nontradables), and so optimal monetary policy—in Nash as well as cooperativeequilibria—entails replicating the flexible-price equilibrium. When η = 0, however,the flexible-price equilibrium cannot be maintained and national welfare is
maximized when exporters’ revenues are stabilized in their own currencies (since thenthe markups on exports are minimized). In that case, a fixed exchange rate ispreferred (both in the Nash and cooperative scenarios, which obviously coincide).
In the middle ground of partial exchange rate pass-through where 0 < η < 1, there isa trade-off between national revenue stabilization and attainment of the flexible-priceequilibrium, so exchange rate movements are muted but not stopped. Here, as in the
5. An interesting research direction is to look at the impact on policy rules and cooperation of international
asymmetries in pricing behavior. Otani (2002) investigates international transmission in a hybrid model in which
different countries’ exporters may follow different invoicing practices for their foreign sales.

31

incomplete-markets case of Obstfeld and Rogoff (2002), there can be some scope forinternational monetary cooperation in choosing monetary policy rules, though its
quantitative importance is likely to be small.
These results can be extended to throw light on the nature of optimum currency
areas, as Corsetti and Pesenti (2002) illustrate. In an extension of their 2001 model,
they allow producers to choose the pass-through percentage η so as to maximize
expected utility.6 Under national monetary rules that target the flexible-price allocation and thus entail exchange rate flexibility, it is optimal for firms to practice PCP,a choice that validates the regime of independent national currencies as optimal.
If firms practice LCP, however, authorities will find fixed exchange rates (or a single
currency) optimal. Under these circumstances, however, firms will actually be
indifferent to the choice of η (after all, the exchange rate is credibly fixed, so it isirrelevant to pricing). It turns out that the national outputs are more highly
correlated under the fixed-rate regime, as one might hope in comparing the merits ofan optimum currency area with those of a floating-rate system, but all countries’
welfare is actually higher under the floating-rate arrangements. Since price-setterswould modify their strategies if authorities dropped fixed exchange rates in favor ofan optimal float, an interesting question is whether fixed rates would be a subgameperfect Nash equilibrium regime. The analysis of Corsetti and Pesenti (2002) implies
that it would not pay for a lone monetary authority unilaterally to defect from afixed-rate regime (given that partner countries continue to peg). In an equilibrium
where policy authorities cooperate to choose the regime, however, countries would
move to floating rates. It is simply not credible for price-setters to “threaten” to retain
LCP if exchange rates are allowed to float.
B. Are the Simplest Models Reliable Guides for Policy?
The models I have discussed are illuminating and intriguing. They well illustrate how
a careful framework built on microfoundations can discipline and inform macroeconomic policy evaluation in a way that simple IS-LM style models simply
cannot. The latter models simply make no attempt to ensure the consistency ofmacroeconomic relationships and welfare criteria.
One must still be extremely cautious, however, in drawing policy conclusions
from specific, and in some cases very special, models. If one takes seriously the
LCP models described in the last subsection, one might conclude in favor of
fixed exchange rate regimes. These models miss at least two critical aspects ofreality, however:• Import prices paid at the point of entry to a country display very different
behavior from the CPI prices of imported goods. Thus, regularities applying to
CPI real exchange rates may have little bearing on import price behavior.
• It may be firms rather than consumers whose decisions are central to theexpenditure-switching effect of the exchange rate. In that case, import prices
at the point of entry will influence economic decisions. Particularly when
6. Bacchetta and van Wincoop (2001) and Devereux and Engel (2001) also present general equilibrium analyses of
the choice of exporters’ currency of invoice.

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firms have multinational operations, the critical relative price for expenditureswitching will be the real exchange rate measured with respect to relative
nominal unit labor costs.
1. Prices in international trade
The extreme assumption of LCP models that the short-run pass-through fromexchange rates to import prices is nil helps rationalize the observed behavior ofreal CPI exchange rates. But prices at earlier stages of importation behave quite
differently from CPI prices. As I have noted, most studies of import or export prices
show considerable pass-through (with 50 percent the median figure) over a one-year
horizon. Once imports reach the consumer, however, they incorporate a substantial
nontradable marketing input, and, moreover, may pass through imperfectly competitive retailing networks so that the link between consumer and original price isweakened further. Corsetti and Dedola (2002) present a formal model along theselines, although they assume that retailing is competitive.
Direct evidence on invoice currencies in trade seems to contradict the LCP assumption for import prices. For most countries—the United States is an outstanding
exception here, as probably is the euro zone by now—imports are mostly invoiced inforeign currencies. There is also some tendency, though weakening over time, for“Grassman’s law” to hold, that is, exports are invoiced in the exporter’s currency. For
the United States, 81 percent of imports and 92 percent of exports were invoiced in thehome currency, the dollar, in 1995. For some other countries, the respective import andexport shares of domestic currency for 1995 were Japan (23 percent and 36 percent),
Germany (52 percent and 75 percent), France (49 percent and 52 percent), the United
Kingdom (43 percent and 62 percent), Italy (37 percent and 40 percent), and theNetherlands (43 percent and 44 percent).7 However, invoicing considerations are only
part of the story, since the stickiness of import and export prices, however invoiced,
may differ from that of retail prices.
In general, import prices, measured in the currency of the country of origin, will
be closely linked to nominal wages at the production point, which themselves adjustquite slowly. On the other hand, import prices will be reasonably responsive to
exchange rates, though often not to the extent that they exhibit full short-run
pass-through. Thus, a currency depreciation will tend to worsen the terms of trade ofthe depreciating country by lowering its relative wage. The evidence shows that thispattern indeed appears strongly in the data (Obstfeld and Rogoff [2000] andObstfeld [2001]), whereas the LCP models discussed above, taken literally, do not
imply that currency depreciation worsens one’s terms of trade. Because wages move
more slowly than prices in international trade, pass-through to import prices should
also be more rapid than pass-through to the general CPI, implying that nominal
depreciation causes real depreciation.
2. Economic effects of exchange rate changes
But do these changes in real relative prices induce economic agents to switch demand
between domestic and foreign goods? Even if exchange rates do not affect the relative
prices consumers face, the answer is yes provided firms respond.
7. These data are reported by Bekx (1998, table 4).

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One development suggesting that firms’ responses are important is the increasing
importance of international outsourcing and trade in intermediate products. Feenstra(1998) and Hummels et al. (2000) document the trends.
Obstfeld (2001) develops a model in which retailing firms can switch between
imported and domestic inputs, with their relative price depending on the relative(preset) wages levels at home and abroad.8 On the other hand, retailing firms preset
the prices of the final consumer goods in terms of home currency, and it is prohibitively costly for consumers to arbitrage between national markets. In this setup,exchange rate movements have important expenditure-switching effects and optimalmonetary policy targets the flexible wage and price allocation. While the model
captures the high empirical correlation between the nominal and real CPI exchange
rates, the stickiness of final-goods prices actually is irrelevant to the realized allocation, so that real CPI exchange rate volatility is irrelevant as well. In its strong form,
this result is due to rather special assumptions (for example, all final consumption
is nontradable, complete home bias in equity holdings, and the law of one price forintermediate tradables).9
A closely related channel comes from firms’ sourcing decisions. Increasingly overthe postwar period, large corporations have established manufacturing facilities acrossthe globe. One important motivation for doing so is diversification. Given stickinessin nominal wages, a currency depreciation will lower the depreciating country’s
relative costs and make it relatively attractive to shift production there.
Intrafirm trade is a significant part of overall international trade. Rangan and
Lawrence (1999, p. 2) report that in 1994, “more than 35 percent of U.S. exports
and almost 43 percent of U.S. imports represented the intrafirm transactions of
U.S.- and foreign-headquartered multinational enterprises.” How does this circumstance affect the trade response to exchange rate changes? Some have argued that
intrafirm transactions may be unresponsive to normal economic incentives. A
counter-argument, however, is that the presence of production facilities in different
countries enhances the international flow of information within the firm, allowing it
to respond more nimbly to international price changes by shifting activities acrossborders. Rauch and Trindade (2002) develop a formal model in which enhanced
information networks increase trade elasticities; see also Grossman and Helpman(2001).10 Rangan and Lawrence (1999) provide evidence that intrafirm trade
responds strongly to exchange rate changes. Figure 1, which is taken from Ranganand Lawrence (1999, p. 89), shows that in the dollar’s 1985–89 depreciation episode,
U.S. multinationals’ foreign affiliates around the world increased their U.S. content
shares, with the possible exception of developing Asian countries, where there wasanyway a strong trend of local content augmentation.11 In any case, the positive

8. McCallum and Nelson (2000) present an alternative open-economy model based on trade in intermediates.
9. See Obstfeld (2002) for further discussion.
10. It would be an important extension of the new open-economy macroeconomics approach to build directly
into economic models the kinds of matching and contracting problems that these authors emphasize. Such an
extension might also allow one to endogenize certain asset-market imperfections.
11. I am grateful to Subi Rangan and Bob Lawrence for providing the data underlying Figure 1.

34 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rates and Adjustment: Perspectives from the New Open-Economy Macroeconomics

correlation between the dollar’s real depreciation and U.S. content increase isstriking. The results indicate substantial expenditure switching by firms involved ininternational trade.
Figure 1 Changes in Real Exchange Rates and U.S. Content Levels in Sales
Made by Majority-Owned Foreign Affiliates of U.S. Multinationals,
Selected Economies, 1985–89
Percent change in U.S. content level1
Japan
60
Switzerland
40

SwedenItaly
Germany

20

Netherlands
United Kingdom

0Australia

CanadaTaiwanIrelandSingapore–20

South Korea
Hong Kong

Malaysia–40

Philippines–10

FranceBelgium

0

Thailand
10

20

30

40

50

Percent change in U.S. real exchange rate2
Notes: 1. The percentage change in U.S. content levels between 1985 and 1989 is thechange in the share of U.S. content in sales made by majority-owned foreign
affiliates of U.S. multinational parents.
2. The U.S. real exchange rate is denominated as U.S. dollars per foreign
currency units; therefore, positive (negative) changes between 1985 and1989 represent a depreciation (appreciation) in the real exchange valueof the dollar.
Source: Rangan and Lawrence (1999, p. 89).

3. Some further evidenceThis subsection takes a very brief look at some new and updated evidence on international prices. Other papers, including Dornbusch (1987) and my own work, bothwith Rogoff (2000) and alone (2001), have looked at related evidence, though here I
follow Dornbusch in looking at somewhat disaggregated data. I take advantage of thedetailed data collected by the governments of Canada and the United States. The findings support the contention that exchange rate changes alter relative international
prices in conventional ways, although the work is preliminary and suggests interestingareas for future inquiry.

35

Table 1 reports correlations between the nominal exchange rate and the relative
export price index using Canadian and U.S. single-digit Standard Industrial Trade
Classification (SITC) categories of exports. All data are monthly.12 Under LCP, acountry’s exports would be priced in the destination-market currency and it is not
obvious that a nominal exchange rate change would enhance the depreciating country’s competitiveness by lowering the relative price of its exports (Obstfeld and Rogoff[2000]). Using either end-of-month or month-average exchange rates, however, one
reaches the conclusion that a nominal depreciation of the Canadian dollar against the
U.S. dollar is associated with a fall in the relative price of Canadian exports. Figures 2
through 9 illustrate the results in graphical form for 12-month log changes. (InFigures 2 through 9, positive changes indicated by the dashed line are depreciationsof the U.S. dollar relative to the Canadian dollar and positive changes indicatedby the solid line are increases in the relative price of Canadian relative to U.S.
exports.) Both the correlation coefficients and the figures suggest considerable
heterogeneity among industrial categories, with some tendency for a lower
correlation for agricultural and natural resource products. The differences across
SITC categories deserve further theoretical and empirical study.
Another relative price that the exchange rate might affect is that between imports
and import competing goods. For Canada, Figures 10 through 16 show (in levels)
the ratio of Canadian import prices to the industrial prices of competing domestic
goods since 1992.13 Particularly for industrial goods and textiles, there is a clear
tendency for a nominal effective depreciation of the Canadian dollar (increase in thedashed line) to raise relative import prices (increase in the solid line).
4. The answer
The consumer prices of imports certainly appear to be sticky in local currency. A
broad consideration of the evidence gives no basis, however, for radically rethinking
the view that exchange rates have significant expenditure-switching effects in open
Table 1 Correlations between Relative Export Price and Nominal Exchange Rate
(Canada–United States)
Sample period: Mar. 1993–Mar. 2001
Category
Food and live animals
Beverages and tobacco
Crude materials, except fuels, inedible
Mineral fuels, lubricants and related materials
Chemicals
Manufactured goods, classified chiefly by material
Machinery and transport equipment
Miscellaneous manufactured articles

Period average
0.16
0.14
0.22
0.36
0.38
0.28
0.84
0.91

End of month
0.27
0.15
0.29
0.30
0.40
0.33
0.81
0.91

Note: Correlations are defined so that a positive number implies that the price of U.S. exports
relative to Canadian exports tends to rise when the Canadian dollar depreciates relative
to the U.S. dollar.
12. Disaggregated Canadian data come from the CANSIM database, whereas U.S. data, matched by SITC, are fromthe Bureau of Labor Statistics. Exchange rates are from the IMF and Global Financial Data.
13. Industrial and import price data are from CANSIM.

36 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rates and Adjustment: Perspectives from the New Open-Economy Macroeconomics

economies. Indeed, for many purposes it is not a very misleading shortcut to abstractfrom distribution channels and assume that consumer import prices respond directly
to exchange rates.
Figure 2 Relative Canada–U.S. Export Price and Bilateral Exchange Rate
Movements: Beverages and Tobacco
Percent

Percent
6

10

0

–10
12-month growth rate ofrelative export price (left scale)
12-month growth rate of nominal
exchange rate (right scale)–20
Mar. 1993–12
Mar. 2001

Figure 3 Relative Canada–U.S. Export Price and Bilateral Exchange Rate
Movements: Chemicals
Percent
20

Percent
612-month growth rate of relative export price (left scale)
12-month growth rate of nominal exchange rate (right scale)

10

0

–10

Mar. 1993–12

Mar. 2001

37

Figure 4 Relative Canada–U.S. Export Price and Bilateral Exchange Rate
Movements: Crude Materials

Percent

Percent
612-month growth rate of relative export price (left scale)
12-month growth rate of nominal exchange rate (right scale)

20

10

0

–10

–12

–20
Mar. 1993

Mar. 2001

Figure 5 Relative Canada–U.S. Export Price and Bilateral Exchange Rate
Movements: Food and Live Animals

Percent

Percent

20

6

10

0

–10

–20

12-month growth rate ofrelative export price (left scale)
12-month growth rate of
nominal exchange rate (right scale)Mar. 199338 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

–12
Mar. 2001

Exchange Rates and Adjustment: Perspectives from the New Open-Economy Macroeconomics

Figure 6 Relative Canada–U.S. Export Price and Bilateral Exchange Rate
Movements: Machinery and Transport Equipment

Percent

Percent

56

012-month growthrate of relative export
price (left scale)
12-month growth rateof nominal exchange
rate (right scale)–5Mar. 1993–12
Mar. 2001

Figure 7 Relative Canada–U.S. Export Price and Bilateral Exchange Rate
Movements: Manufactured Goods

Percent

Percent

20

612-month growth rate of relative export price (left scale)
12-month growth rate of nominal exchange rate (right scale)

10

0

–10

–20
Mar. 1993–12
Mar. 2001

39

Figure 8 Relative Canada–U.S. Export Price and Bilateral Exchange Rate
Movements: Mineral Fuels, Lubricants, Etc.

Percent

Percent
612-month growth rate of relative export price (left scale)
12-month growth rate of nominal exchange rate (right scale)

50

0

–50

–12

Mar. 1993

Mar. 2001

Figure 9 Relative Canada–U.S. Export Price and Bilateral Exchange Rate
Movements: Miscellaneous Manufactured Articles
Percent

Percent

10612-month growth rate of relative export price (left scale)
12-month growth rate of nominal exchange rate (right scale)

5

0

–5

–10
Mar. 1993

40 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

–12
Mar. 2001

Exchange Rates and Adjustment: Perspectives from the New Open-Economy Macroeconomics

Figure 10 Import-Industrial Price Ratio and Nominal Effective Exchange Rate
Movements for Canada: Beverages

Import price/Industrial priceNominal effective exchange rate

110

110

100

Import price/Industrial price(left scale)
Nominal effective exchange
rate (right scale)90

Jan. 1992

83
Mar. 2001

Figure 11 Import-Industrial Price Ratio and Nominal Effective Exchange Rate
Movements for Canada: Fish

Import price/Industrial priceNominal effective exchange rate

120

110
Import price/Industrial price (left scale)
Nominal effective exchange rate (right scale)

110

100

90

83

80
Jan. 1992

Mar. 2001

41

Figure 12 Import-Industrial Price Ratio and Nominal Effective Exchange Rate
Movements for Canada: Meat
Import price/Industrial priceNominal effective exchange rate
110

140

120

100

Import price/Industrial price (left scale)
Nominal effective exchange rate (right scale)
83

80
Jan. 1992

Mar. 2001

Figure 13 Import-Industrial Price Ratio and Nominal Effective Exchange Rate
Movements for Canada: Metal Fabricated Basic Products

Import price/Industrial priceNominal effective exchange rate
110

110

100

90

Import price/Industrial price (left scale)
Nominal effective exchange rate (right scale)
83

80
Jan. 1992

42 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Mar. 2001

Exchange Rates and Adjustment: Perspectives from the New Open-Economy Macroeconomics

Figure 14 Import-Industrial Price Ratio and Nominal Effective Exchange Rate
Movements for Canada: Motor Vehicle Parts

Import price/Industrial priceNominal effective exchange rate

110

110

105

100

Import price/Industrial price (left scale)
Nominal effective exchange rate (right scale)

95

83
Jan. 1992

Mar. 2001

Figure 15 Import-Industrial Price Ratio and Nominal Effective Exchange Rate
Movements for Canada: Textiles

Import price/Industrial priceNominal effective exchange rate

110

110

105

100

95
Import price/Industrial price (left scale)
Nominal effective exchange rate (right scale)90
Jan. 1992

83

Mar. 2001

43

Figure 16 Import-Industrial Price Ratio and Nominal Effective Exchange Rate
Movements for Canada: Tobacco

Import price/Industrial price140

Nominal effective exchange rate

Import price/Industrial price (left scale)
Nominal effective exchange rate (right scale)

110

120

100

80

60
Jan. 1992

83

Mar. 2001

IV. Conclusion
In this paper, I have argued that the limited pass-through of exchange rate changes to
consumer import prices does not lead to the conclusion that optimal policy regimes
should sharply limit exchange rate movements. Two factors (at least) can sharply
modify the conclusions of the simplest macroeconomic models based on local currency
pricing. One is the chain of transactions linking import prices at the point of entry to
the ultimate prices consumers pay. Another is the important role of firms’ sourcing
decisions in a world of globalized production. Richer models that incorporate theseempirically relevant features point to an important role for the exchange rate inswitching expenditure between countries. The new open-economy macroeconomics
provides an ideal setting in which to explore these questions.
The preceding conclusions can break down for very open economies or in
conditions in which nominal wages and prices become flexible. Notwithstanding thetechnological and organizational factors that are effectively reducing economic
distance day by day, the larger industrial currency areas are still insular enough thatexchange rate changes seem likely to remain effective into the foreseeable future.

44 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rates and Adjustment: Perspectives from the New Open-Economy Macroeconomics
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