Nominal Rigidities and Exchange Rate Pass-Through in a Structural Model of a Small Open Economy

The authors analyze exchange rate pass-through in an estimated structural model of a small open economy that incorporates three types of nominal rigidity (wages and the prices of domestically produced and imported goods) and eight different structural shocks. The model is estimated using quarterly data from Canada and the United States. It predicts a remarkably similar dynamic relationship between the nominal exchange rate and prices in response to the different structural shocks: the nominal exchange rate overshoots its long-run level, and changes in the nominal exchange rate are passed through slowly to the domestic price level. The authors show that, although pricing to market (the slow adjustment of the domestic-currency prices of imported goods) is necessary to generate slow pass-through to the prices of imported goods, it is not necessary to generate slow pass-through to the overall price level. Sticky domestic wages also generate slow exchange rate pass-through, even when the prices of imported goods adjust instantaneously to changes in the exchange rate.