Can trade costs explain why exchange rate volatility does not feed into consumer prices?

Journal of Monetary Economics, 2008, vol. 55, issue 3, pages 606-628

Abstract: If countries specialize in imperfectly substitutable goods, trade costs increase the share of expenditure devoted to domestic output, reducing the exposure of consumer price inflation to exchange rate changes. I present a multi-country flexible-price model where expenditure shares are inversely related to trade costs through a gravity equation. In this setting, consumer price inflation can be approximated as an expenditure-share-weighted average of the contributions to inflation from all countries. I use data from 24 OECD countries, 1970-2003, to estimate a structural gravity model. I combine the fitted expenditure shares from the estimation with actual data on exchange rates to construct predictions of inflation. The behavior of these predictions indicates that trade costs can explain both qualitatively and quantitatively the failure of exchange rate volatility to feed into inflation.

Date: 2008

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Journal of Monetary Economics is edited by R. G. King and C. I. Plosser

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