UCLA

In these essays, I examine exchange rates and prices in the context of a small open economy.

My first chapter is an empirical study of the behavior of nominal and real exchange rates in Mexico in the last 20 years. I present facts for exchange rate pass-through to prices, using both aggregate prices and CPI micro-data.

I structure the evidence in two sets of facts that highlight the importance of real shocks and monetary regime in explaining changing patterns of aggregate prices and the CPI micro data.

The first set shows that the nominal and real exchange rates have a strong co-movement at short and medium run horizons. Second, real exchange rate movements are mostly explained by changes in relative prices between `at the dock' prices and retail prices. Third, there is a large nominal exchange rate shock, the reason behind the incomplete exchange rate pass-through and the increase in the real exchange rate is not a slow price adjustment of goods that are actually traded, but a less-than-proportional adjustment of retail prices.

The second set of facts analyzes the behavior of individual prices used to compute the CPI. First, there is a positive correlation between the fraction of prices that adjust per period (i.e., the frequency of price adjustment) and the level of inflation. Second, this correlation and the role of these changes in the fraction of adjusting prices in inflation is mostly explained by the exchange rate pass through after the 1994 large currency devaluation episode.

In the second chapter I study the role of nominal price rigidities in accounting for low CPI inflation after large currency depreciations. Using a small open economy model with menu-cost nominal frictions calibrated to micro data from Mexico's Consumer Price Index, I find that in episodes of large depreciations, the effects of nominal rigidities in retail prices are quantitatively small and short-lived. The incomplete exchange rate pass-through to consumer prices is largely a result of a fall in real wages caused by negative real shocks and nominal stickiness in wages

In my third chapter I present a model of a small open economy subject both to a collateral constraint and downward rigidity in wages. These constraints will interact generating external shocks amplification and, in the presence of a currency peg regime, it also generates unemployment. This can be seen as an example that captures two main themes for small open economies: real exchange rigidities and consumption volatility. The contributions of my chapter are twofold. First, I show how financial amplification effects caused by `over borrowing can generate high unemployment rates without resorting to extreme wage rigidity. Second, it shows that the exchange rate policy faces a tradeoff between unemployment and tradable consumption when the collateral constraint binds. These two insights reflect the tradeoff of maintaining a currency peg during a crises: higher unemployment or an amplification of financial amplification of shocks.