We propose a continuous time model to investigate the impact of inflation credibility on sovereign debt dynamics. At every point in time, an impatient government decides fiscal surplus and inflation, without commitment. Inflation is costly, but reduces the real value of outstanding nominal debt. In equilibrium, debt dynamics is the result of two opposing forces: (i) impatience and (ii) the desire to conquer low inflation. A large increase in inflation credibility can trigger a process of debt accumulation. This rationalizes the sovereign debt booms that are often experienced by low inflation credibility countries upon joining a currency union.
We survey the recent empirical and theoretical developments in the literature on the relation between prices and exchange rates. After updating some of the major findings in the empirical literature we present a simple framework to interpret this evidence. We review theoretical models that generate insensitivity of prices to exchange rate changes through variable markups, both under flexible prices and nominal rigidities, first in partial equilibrium and then in general equilibrium.
We empirically characterize the mechanics of trade adjustment during the Argentine crisis. Though imports collapsed by 70 percent from 2000-2002, the entry and exit of firms or products at the country level played a small role. The within-firm churning of imported inputs, however, played a sizeable role. We build a model of trade in intermediate inputs with heterogeneous firms, fixed import costs, and roundabout production. Import demand is non-homothetic and the implications of an import price shock depend on the full distribution of firm-level adjustments. An import price shock generates a significant decline in productivity.
We show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a dynamic New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions—producer or local currency pricing, along with nominal wage stickiness; under arbitrary degrees of asset market completeness and for general stochastic sequences of devaluations. There are two types of fiscal policies equivalent to an exchange rate devaluation—one, a uniform increase in import tariff and export subsidy, and two, a value-added tax increase and a uniform payroll tax reduction. When the devaluations are anticipated, these policies need to be supplemented with a consumption tax reduction and an income tax increase. These policies are revenue neutral. In certain cases equivalence requires, in addition, a partial default on foreign bond holders. We discuss the issues of implementation of these policies, in particular, under the circumstances of a currency union.
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 1960s, 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 co-authors and I shed light on these questions by providing evidence for actual traded goods prices. Using micro-data on U.S. 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.
We document the behavior of trade prices during the Great Trade Collapse of 2008-2009 using transaction-level data from the U.S. Bureau of Labor Statistics. First, we find that differentiated manufactures exhibited marked stability in their trade prices during the large decline in their trade volumes. Prices of non-differentiated manufactures, by contrast, declined sharply. Second, while the trade collapse was much steeper among differentiated durable manufacturers than among non-durables, prices in both categories barely changed. Third, despite this lack of movement in average price levels, the frequency and magnitude of price adjustments at the product level noticeably changed with the onset of the crisis.
The closed and open economy literatures work on estimating real rigidities, but in parallel. We bring the two literatures together to shed light on this question. We use international price data and exchange rate shocks to evaluate the importance of real rigidities in price setting. We show that consistent with the presence of real rigidities the response of reset-price inﬂation to exchange rate shocks depicts signiﬁcant persistence. Individual import prices, conditional on changing, respond to exchange rate shocks prior to the last price change. At the same time aggregate reset-price inﬂation for imports, like that for consumer prices, depicts little persistence. Competitors prices effect ﬁrm pricing and exchange rate pass-through into import prices are greater in response to trade-weighted as opposed to bilateral exchange rate changes. We quantitatively evaluate sticky price models (Calvo and menu cost) with variable markups at the wholesale level and constant markups at the retail level, consistent with empirical evidence. Variable markups alone generate sluggishness in price adjustment and increase the size of the contract multiplier, but their effects are modest.
Relative cross-border retail prices, in a common currency, comove closely with the nominal exchange rate. Using product-level prices and wholesale costs from a grocery chain operating in the United States and Canada, we decompose this variation into relative costs and markup components. The high correlation of nominal and real exchange rates is driven mainly by changes in relative costs. National borders segment markets. Retail prices respond to changes in costs in neighboring stores within the same country but not across the border. Prices have a median discontinuous change of 24 percent at the border and 0 percent at state boundaries. (JEL F31, L11, L81)
We show, using novel data on currency and prices for US imports, that even conditional on a price change, there is a large difference in the exchange rate pass-through of the average good priced in dollars (25 percent) versus nondollars (95 percent). We document this to be the case across countries and within disaggregated sectors. This finding contradicts the assumption in an important class of models that the currency of pricing is exogenous. We present a model of endogenous currency choice in a dynamic price setting environment and show that the predictions of the model are strongly supported by the data. (JEL E31, F14, F31)
We empirically document using U.S. import prices that on average goods with a high frequency of price adjustment have a long-run pass-through that is at least twice as high as that of low-frequency adjusters. We show theoretically that this relationship should follow because variable mark-ups that reduce long-run pass-through also reduce the curvature of the profit function when expressed as a function of the cost shocks, making the firm less willing to adjust its price. Lastly, we quantitatively evaluate a dynamic menu-cost model and show that the variable mark-up channel can generate significant variation in frequency, equivalent to 37% of the observed variation in the data. On the other hand the standard workhorse model with constant elasticity of demand and Calvo or state dependent pricing has difficulty matching the facts.
We characterize optimal taxation of foreign capital and optimal sovereign debt policy in a small open economy where the government cannot commit to policy, seeks to insure a risk-averse domestic constituency, and is more impatient than the market. Optimal policy generates long-run cycles in both sovereign debt and foreign direct investment in an environment in which the first best capital stock is a constant. The expected tax on capital endogenously varies with the state of the economy, and investment is distorted by more in recessions than in booms, amplifying the effect of shocks. The government's lack of commitment induces a negative correlation between investment and the stock of government debt, a “debt overhang” effect. Debt relief is never Pareto improving and cannot affect the long-run level of investment. Furthermore, restricting the government to a balanced budget can eliminate the cyclical distortion of investment.