The exchange rate in a model of pricing-to-market

Much recent evidence suggests that exchange rate movements have very little effect on prices of traded goods. This paper presents some fresh evidence on this phenomenon, and develops a general equilibrium model consistent with the non-response of prices to exchange rate movements that are generated by money shocks. In the model some firms engage in pricing-to-market (PTM) across countries, The main question addressed is the degree to which PTM itself affects the behaviour of the exchange rate. It is shown that the presence of pricing-to-market combined with sticky local-currency nominal prices magnifies the response of the exchange rate to money shocks, and that the degree of exchange rate variability may be increased considerably relative to a model where the law of one price holds continuously.