Exchange Rate Economics: Theories and Evidence

280 The new open economy macroeconomics part 2
using the properties of the profit functions mentioned earlier under the different
Nash conditions to see which yields the highest expected utility. Given the demand
function (11.13),and defining _ n = 0.5 − 0.5/µ(η − 1),this leads to the following
pricing strategies:
• If µ(η − 1) 1 and n < ¯n firms price in the importer’s currency;
• If µ(η − 1) >1 and n > ¯n there are three Nash Equilibria: all price in the
exporter’s currency; all price in the importer’s currency; a fraction prices in
the exporter’s currency,while the rest price in the importer’s currency.
In the final case if firms coordinate they will prefer to all price in the exporter’s
currency if either _ n or their rate of risk aversion are large enough. The three pricing
strategies make clear that the market share of the exporting country is crucial in
determining the pricing decision – if the market share is small below the cut-off, _ n,
then the results are unchanged compared to the single exporting firm considered
in the partial equilibrium model: if demand is sufficiently price elastic firms price
in the importer’s currency. More generally,the results show that firms are more
likely to price in the exporter’s currency if their country’s market share is large.
Bacchetta and van Wincoop then go on to consider invoicing practice in the
context of a general equilibrium set-up which is in the spirit of the NOEM. The
key difference in moving from the partial to general equilibrium setting is that
the exchange rate is no longer exogenous. Their variant of the NOEM model is
one in which there are two tradable sectors and a non-tradable sector and the
only source of uncertainty comes from money supply shocks. They show that
the invoicing results are crucially dependent on the assumption regarding wage
flexibility. With wages preset Bacchetta and van Wincoop show that the pricing
strategies for firms are very similar to those outlined earlier in the case of the
partial equilibrium set-up: 2 market share is still the critical factor in determining
the invoicing currency.
In a related paper,Devereux et al. (2001) use the basic NOEM model of the
previous chapter to develop a model of endogenous exchange rate pass-through,
where both pass-through and the exchange rate are simultaneously determined
and interact with one another. The main distinguishing features of Devereux et al.
over Bacchetta and van Wincoop is that they focus on exchange rate pass-through
and exchange rate volatility and the implications for exchange rate volatility of
differences in monetary policies across countries. In the model of Devereux et al.,
pass-through is endogenous because firms choose the currency in which they set
their export prices and,assuming exchange rate volatility increases as the degree of
pass-through falls,they demonstrate that there is a unique equilibrium rate of passthrough.
Importantly,they show that exchange rate volatility may be substantially
affected by the presence of endogenous pass-through. The key results of Devereux
et al. show that pass-through is related to the relative stability of monetary policy:
countries which have relatively low monetary growth have relatively low rates of