Queen’s Economics Department Working Paper No. 1418
We develop an open economy monetary model with heterogeneous households which is characterized by incomplete pass-through of exchange rate movements to import prices. Partial pass-through arises in our environment due to the presence of competitive search in international goods' markets. Under competitive search, agents choose a submarket in which to exchange goods, where different submarkets are characterized by different price and trading probability combinations. Preference and policy shocks which induce exchange rate movements cause households to choose a different submarket for their purchases of traded goods-an extensive margin response. These responses mitigate the direct effect of nominal exchange rate changes on equilibrium traded goods' prices, thereby generating incomplete exchange rate pass-through to goods' prices. In the calibrated model, exchange rate pass-through due to foreign shocks ranges between 19% and 62%, which is in the range of import price pass-through estimates for developed economies. Due to risk aversion by households, the magnitude of pass-through depends on the size and direction of the initial shock, making the model consistent with the observed phenomenon of asymmetric pass-through. Importantly, by incorporating household heterogeneity, we are able to examine the role of precautionary savings in affecting pass-through, characterize how pass-through varies across different types of households, and examine the distributional effects of exchange rate movements.