State-dependent pricing, Variable Mark-ups and Pass-through

The frequency of price adjustment is a central topic of research in macroeconomics. Recently, there has been a surge in empirical research on the measures of this frequency. A consistent finding across all the studies is that there is significant heterogeneity in the frequency of price adjustment, even at highly disaggregated levels. What explains why some firms adjust prices more frequently than others? In theory there are several factors that effect the frequency of adjustment such as menu costs, the magnitude of demand and supply shocks, parameters that effect the curvature of demand and the curvature of the cost function. It is in general difficult to obtain estimates of these parameters in the data and consequently to empirically test the theory. Moreover, in the closed economy literature, there are no evidently measureable sizeable shocks. In this paper we use the open economy context to shed light on this question. The open economy context provides an interesting laboratory to address this question for the following reasons-(i) There is a well identified and sizeable cost shock which is the exchange rate shock. (ii) Exchange rate pass-through, which can be measured, is determined by the same underlying cost and demand parameters. We empirically document a robust positive relationship between the frequency of price adjustment and long-run exchange rate pass-through of importers into the US. We examine the theoretical relation between frequency and pass-through and calibrate a menu-cost pricing model with variable mark-ups to match the facts in the data.