Abstract: Over the past twenty years, U.S. import prices have become less
responsive to the exchange rate. We propose that a significant
portion of this decline is a result of increased trade integration.
To illustrate this effect, we develop an open economy DGE model in
which trade occurs along both the intensive and extensive margins.
The key element we introduce into this environment is strategic
complementarity in price setting. As a result, a firm's pricing
decision depends on the prices set by its competitors. This feature
implies that a foreign exporter finds it optimal to vary its markup
in response to shocks that change the exchange rate, insulating
import prices from exchange rate movements. With increased trade
integration, exporters have become more responsive to the prices of
their competitors and this change in pricing behavior accounts for a
significant portion of the observed decline in the sensitivity of
U.S import prices to the exchange rate.
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Last update: August 22, 2006