The relative prices of nontradables in terms of tradables: a strong indicator of inßation inertia

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The relative prices of nontradables in terms of tradables: a strong indicator of inßation inertia Preliminary Version Anne-Laure Baldi? FORUM Université Paris 10 March 2003 Abstract This paper examines the impact of a shock to the nominal exchange rate on the behavior the relative price of nontradable (N.T.) goods in terms of tradables (T). We develop a simple model of a small open economy producing T and N.T. goods with a monopolistic competition à la Dixit- Stiglitz (1977) and a sticky information context à la Mankiw and Reiss 2002) in the N.T. sector. The model predicts inßation inertia in the overall economy following a shock to the nominal exchange rate. The dynamic e?ects of monetary policy on inßation and real activity currently give rise to a large debate among macroeconomists who discuss di?erent versions of Philipps curve (see Woodford (2002), Mankiw and Reis (2002)). The nominal echange rate as a monetary policy instrument and its impact on real variables is however not speci?cally treated. Nevertheless the issue has been crucial over the last decade in many emerging countries: large adjustments of the relative price of nontradables in terms of tradables were observed ( see ?gure ?? in annex ) after the sudden and permanent shift in the nominal exchange rate due to the implementation of a pegged regime (1989 in Mexico, 1991 in Argentina and Chile and 1995 in Brasil) or inversely after its abandon (1995 in Mexico, 1999 in Brasil and Chile and 2002 in Argentina) According to the law of one price,

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Therelativepricesofnontradablesintermsoftradables:astrongindicatorofinßationinertiaPreliminaryVersionAnne-LaureBaldi∗FORUMUniversitéParis10March2003AbstractThispaperexaminestheimpactofashocktothenominalexchangerateonthebehaviortherelativepriceofnontradable(N.T.)goodsintermsoftradables(T).WedevelopasimplemodelofasmallopeneconomyproducingTandN.T.goodswithamonopolisticcompetition‡laDixit-Stiglitz(1977)andastickyinformationcontext‡laMankiwandReiss2002)intheN.T.sector.Themodelpredictsinßationinertiaintheoveralleconomyfollowingashocktothenominalexchangerate.ThedynamiceﬀectsofmonetarypolicyoninßationandrealactivitycurrentlygiverisetoalargedebateamongmacroeconomistswhodiscussdiﬀerentversionsofPhilippscurve(seeWoodford(2002),MankiwandReis(2002)).ThenominalechangerateasamonetarypolicyinstrumentanditsimpactonrealvariablesishowevernotspeciÞcallytreated.Neverthelesstheissuehasbeencrucialoverthelastdecadeinmanyemergingcountries:largeadjustmentsoftherelativepriceofnontradablesintermsoftradableswereobserved(seeÞgure??inannex)afterthesuddenandpermanentshiftinthenominalexchangerateduetotheimplementationofapeggedregime(1989inMexico,1991inArgentinaandChileand1995inBrasil)orinverselyafteritsabandon(1995inMexico,1999inBrasilandChileand2002inArgentina)Accordingtothelawofoneprice,shiftsinthenominalexchangeratetheoreticallyimplyoverallpriceadjustmentunlessasymetricrigidities(suchasdiﬀerentsectoraladjustmentspeeds)allowsforastaggeredpriceadjustmentinsome∗IwouldliketothankMichelAgliettaforhisinsightfulremarks.Iamalsogratefultomycolleagues,particularlyto,V.Bignon,R.BretonandS.Galantifortheirinsighfulcomments.Alltheremainingerrorsaremine.Adress:UniversitéParis10-Nanterre,B‚t.K.200,avenuedelaRépublique.92000Nanterre.Tél:01-40-97-59-13abaldi@u-paris10.fr1

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