This paper proposes a methodology for tracing out the effect of intermediate inputs, including ‘processing trade’, on the link between external rebalancing and relative price adjustment. We find that neglect of inputs distorts parameterization of the traditional multi-sector macro model. Distortions affect the link between external rebalancing and relative price through several opposing channels. (1) Mismeasured imported inputs exaggerate economic openness and understate the price response to rebalancing. (2) Mismeasured domestic inputs increase cross- sectoral asymmetry in openness, leading to an overstated price response. (3) Mismeasured price elasticities tend to overstate the price response. (4) Distortions in model parameters interact to generate a sizable further understatement of the price response. Quantitative results show that the identified channels can each be significant in economic terms.
external sector adjustment intermediate inputs real exchange rate transfer problem