Since the abandonment of fixed exchange rates in 1973, foreign exchange markets have experienced a great deal of turbulence. However, the large swings in exchange rates under the era of floating have not brought about comparable variation in inflation or disinflation rates as one would expect with pass-through. Instead, volatile nominal exchange rates have translated into volatile real exchange rates in the post-Bretton Woods world, while prices locally have remained remarkably stable.
In an attempt to understand these developments, this paper develops a model of goods market segmentation wherein firms may systematically price discriminate to stabilize prices and quantities across market destinations. Motivated by a preponderance of empirical evidence disavowing the law of one price, the model details some of the economic implications of pricing-to-market behavior. Specifically, the framework examines some of the macroeconomic consequences of market segmentation and shows the resulting behavior of international prices to be broadly in line with the stylized facts. The results include both cross-sectional implications regarding nominal prices and time-series implications regarding relative prices.
Across different trade patterns, significant variation exists in the degrees of pass-through and pricing to market depending upon the degree of intraindustry trade and the substitutability between domestic and foreign goods. Across time, dynamic adjustment in prices suggests that nominal and real exchange rates move together over the short run and over the longer run as well to the extent that markets remain segmented. Overall, pricing to market provides a potentially important source of local price stickiness and real exchange rate variability and persistence.