Prices and Exchange Rates: A Theory of Disconnect

I present a sticky-wage model of exchange rate pass-through with heterogeneous producers and endogenous markups. The model shows that low levels of exchange rate pass-through to firm- and aggregate-level import prices coexist with large in trade flows. After an exchange rate shock, aggregate import prices are subject to a composition bias due to changes in the extensive margin of trade (the number of goods traded between countries). At the firm level, each producer adjusts its markups depending on its own productivity and the change in the competitive environment generated by the exchange rate movement. Firm-level price responses are asymmetric---different for appreciations and depreciations---and adjustments in the intensive margin of trade (firm-level exports) are substantial. In general equilibrium, the model shows that firm reallocations increase the persistence exogenous shocks.