State dependent pricing and exchange rate pass-through

We analyze exchange rate pass-through and volatility of import prices in a dynamic framework where firms are subject to menu costs and decide on price adjustments in response to exchange rate innovations. The exchange rate pass-through and import price volatility then depend on the pricing convention in combination with functional forms of cost and demand functions. In particular, there is lower pass-through, less frequent price adjustments, lower price volatility, and slightly lower average prices when prices are set in the importer s currency than when prices are set in the exporter s currency. The degree of pass-through also depends on the magnitude of exchange rate innovations. Large exchange rate innovations raise pass-through if prices are set in the importer s currency but reduce pass-through if prices are set in the exporter s currency. Finally, the presence of inflation can generate a substantial asymmetry in price adjustments. This asymmetry could lead to pitfalls when empirically estimating pass-through, and we present some potential resolutions to this estimation problem.