Endogenous Exchange Rate Pass-through

This paper develops a model of endogenous exchange rate pass-through an open economy, where both pass-through and the exchange rate are simultaneously determined, and interact with one another. Pass-through is endogenous because firms have the choice of which currency in which they set their export prices. There is a unique equilibrium rate of pass-through under the condition that exchange rate volatility rises as the degree of pass-through falls. We show that the relationship between exchange rate volatility and economic structure may be substantially affected by the presence of endogenous pass-through. Our key results show that pass-through is related to the relative stability of monetary policy. Countries with relatively low volatility of money growth will have relatively low rates of exchange rate pass-through, while countries with relatively high volatility of money growth will have relatively high pass-through rates. 2Introduction A large body of empirical evidence has found that pass-through of exchange rate changes to import prices is less than complete.1 However, the degree of pass-through is