Pricing-to-market in business cycle models

Thu, 01 Jan 2026 00:00:00 +0000

This paper evaluates five microfounded pricing-to-market (PTM) mechanisms and one reduced-form aggregator in a two-country DSGE model with volatile exchange rates driven by financial shocks (following Gabaix and Maggiori 2015) and real productivity shocks. The central question is whether existing open-economy theories can jointly achieve three empirically mandated targets — low exchange-rate pass-through to import prices, muted expenditure switching (low short-run trade elasticity), and plausible producer markups — when exchange rates are volatile and act as a major independent source of fluctuations. The paper’s main contribution is to show analytically and quantitatively that no existing microfounded PTM model fully escapes a structural tension among these three targets, which the authors call the parameterization trilemma.

A Quantitative Microfounded Model for the Integrated Policy Framework

Many emerging market central banks that run inflation targeting frameworks nonetheless intervene in foreign exchange markets, and some use capital flow management tools, particularly when capital flows are volatile – an asymmetry with advanced economy central banks that this paper sets out to quantify rather than merely describe. The vehicle is a microfounded two-country New Keynesian model with two financial frictions similar to those in the three-period model of Basu et al. (2020): a Gabaix-Maggiori (2015) limit on the risk-bearing capacity of FX-market traders, which makes the uncovered interest parity premium fluctuate inefficiently, and an occasionally binding external debt limit in the sudden-stop tradition, which can produce sharp spread increases, current account reversals and deep contractions. To these are added conventional price and wage stickiness plus indexation and high exchange-rate pass-through to import prices, which stand in for weakly anchored medium-term inflation expectations, and a nonlinear Kimball aggregator that lets inflation respond asymmetrically – more to depreciations than to appreciations. The model is calibrated to a representative small open emerging market and, for comparison, a representative small open advanced economy; crucially, “we deliberately assume no systematic differences in the conduct of monetary policy between AEs and EMEs,” so the asymmetry has to come from structure. The calibration is disciplined against outside evidence: the FX-shallowness parameter is 0.06 for the emerging market and 0.02 for the advanced economy, with the emerging market value chosen so that FX purchases worth 10 percent of GDP produce roughly a 15 percent depreciation, in line with Adler, Lisack and Mano (2019); intermediary and portfolio-investor home-ownership shares of 0.75 deliver an unhedged FX exposure for the median emerging market of around 16 percent of GDP, in line with IMF (2021); and the debt limit is set so steady-state debt sits 12 percentage points of annual GDP below the constraint, putting the economy in the constrained regime about 3 percent of the time. Model impulse responses to a 10 percent depreciation sit inside the 90 percent confidence bands estimated by Brandao-Marques et al. (2021) for both country groups, and reproduce contractionary depreciations in emerging markets. The central experiment is a risk-appetite shock, AR(1) with persistence 0.95, scaled to depreciate the advanced economy’s real exchange rate by about 10 percent: in the advanced economy it behaves like an expansionary demand shock that policy can look through, while in the emerging market inflation rises persistently, the central bank tightens, and output contracts. The authors then evaluate simple rules using stochastic simulations, with welfare measured in permanent consumption-equivalent units and, for robustness, a quadratic loss with a weight of one-third on the output gap. An FX intervention rule leaning against the portfolio-driven UIP premium eliminates sudden stops entirely in their setup and improves welfare by more than simply removing the debt limit – so most of the benefit comes from smoothing the UIP premium, not from crisis prevention. A precautionary capital flow management rule leaning against net foreign liability accumulation also generates substantial gains, part of them from taxing foreign investors and from a stronger average real exchange rate. Combining the two does better still. But an FX intervention rule that fires only when the borrowing limit binds, while it does blunt the spread spike, prevents the needed external adjustment, and both welfare criteria judge it detrimental on balance. Finally, in an advanced-economy liquidity trap where output falls about 8 percent and the policy rate is pinned at zero, sterilized FX purchases of 20 percent of annual trend GDP in the first quarter stimulate output and keep CPI inflation closer to target – Svensson’s “foolproof way” – though when the same policy is run by a bloc half the size of the world economy and the foreign economy is also at its lower bound, the spillovers can be “sizable beggar-thy-neighbor effects, even to the extent of being globally contractionary in the short run.”

Marcin Kolasa | Macro Paper Warehouse

Pricing-to-market in business cycle models

A Quantitative Microfounded Model for the Integrated Policy Framework