Publications
Working Papers
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with Dmitry Mukhin
Econometrica, October 2024, forthcoming
MFA Best Paper Award in Asset Pricing, June 2021
NBER Working Paper No. 28950, June 2021
NBER IFM Program Reporter, April 2024
The Mussa (1986) puzzle is the observation of a sharp and simultaneous increase in the volatility of both nominal and real exchange rates following the end of the Bretton Woods System of pegged exchange rates in 1973. It is commonly viewed as a central piece of evidence in favor of monetary non-neutrality because it is an instance in which a change in the monetary regime caused a dramatic change in the equilibrium behavior of a real variable (the real exchange rate) and is often further interpreted as direct evidence in favor of models with nominal rigidities in price setting. This paper shows that the data do not support this latter conclusion because there was no simultaneous change in the properties of the other macro variables, nominal or real. We show that an extended set of Mussa facts equally falsifies both conventional flexible-price RBC models and sticky-price New Keynesian models as explanations for the Mussa puzzle. We present a resolution to the broader Mussa puzzle based on a model of segmented financial market — a particular type of financial friction by which the bulk of the nominal exchange rate risk is held by financial intermediaries and is not shared smoothly throughout the economy. We argue that rather than discriminating between models with sticky versus flexible prices, or monetary versus productivity shocks, the Mussa puzzle provides sharp evidence in favor of models with monetary non-neutrality arising in the financial market, suggesting the importance of monetary transmission via the risk premium channel.
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We use a general open-economy wedge-accounting framework to characterize the set of shocks that can account for major exchange rate puzzles. Focusing on a near-autarky behavior of the economy, we show analytically that all standard macroeconomic shocks — including productivity, monetary, government spending, and markup shocks — are inconsistent with the broad properties of the macro exchange rate disconnect. News shocks about future macroeconomic fundamentals can generate plausible exchange rate properties. However, they show up prominently in contemporaneous asset prices, which violates the finance exchange rate disconnect. International shocks to trade costs, terms of trade and import demand, while potentially consistent with disconnect, do not robustly generate the empirical Backus-Smith, UIP and terms-of-trade properties. In contrast, the observed exchange rate behavior is consistent with risk-sharing (financial) shocks that arise from shifts in demand of foreign investors for home-currency assets, or vice versa.
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What Drives US Import Price Inflation?
with Mary Amiti and David E. Weinstein
Inflation has risen sharply in many countries since the COVID-19 outbreak, and economists have debated the underlying causes. In this paper, we examine the drivers of the global import price inflation, which peaked at approximately 11 percent a year. We find that a common global component closely tracks movements in aggregate US import prices until late 2022. Afterward, idiosyncratic US demand shocks started to dominate.
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After a wave of globalization following the end of the Cold War, trade wars and financial sanctions have become frequent tools of international policymaking over the last ten years. This renewal has led to an increased interest in the welfare and allocative consequences, and more generally the overall effectiveness of international sanctions. Studying these questions in Itskhoki and Mukhin (2022), we show that Lerner symmetry provides an important benchmark with import and export sanctions equivalent in terms of their effects on allocations and welfare. However, this analysis abstracts from several practical issues, including the timing of sanctions, the interactions between trade and financial restrictions, and the effects of sanctions on the financial sector. This article incorporates these features into the model and studies their implications for the equivalence of export and import sanctions, emphasizing points of departure from Lerner symmetry.
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We analyze how firms choose the currency of invoicing and the implications of this choice for exchange rate pass-through into export prices and quantities. Using a new dataset for Belgian firms, we find currency invoicing to be an active firm-level decision, shaped by the firm’s size, exposure to imported inputs, and the currency choices of its competitors. Our results show that the firm’s currency choice, in turn, has a direct causal impact on the exchange rate pass-through into prices and quantities. Moreover, the differential price response of similar firms that invoice in different currencies is large, persists beyond a one-year horizon, and gradually wanes in the long run. This results in allocative expenditure-switching effects on export quantities, which build up over time, suggesting a role for quantity adjustment frictions in addition to price stickiness. Our findings shed light on the mechanisms that make or break a dominant currency and the consequences it has for the international transmission of shocks.
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A handful of currencies, especially the US dollar, play a dominant role in international trade. We survey the active theoretical and empirical literature that documents patterns of currency use in global trade, the implications of dominant currencies for international transmission of shocks, exchange rate pass-through, expenditure switching, and optimal monetary policy. We describe advances in the endogenous currency choice literature including conditions for the emergence and persistence of dominant currency equilibria.
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Exchange Rate Disconnect in General Equilibrium
with Dmitry Mukhin
Journal of Political Economy, August 2021, 129(8): 2183–2232. Lead article
Winner of the 2023 Robert E. Lucas Jr. Prize
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We propose a dynamic general equilibrium model of exchange rate determination that accounts for all major exchange rate puzzles, including Meese-Rogoff, Backus-Smith, purchasing power parity, and uncovered interest rate parity puzzles. We build on a standard international real business cycle model with home bias in consumption, augmented with shocks in the financial market that result in a volatile near-martingale behavior of exchange rates and ensure their empirically relevant comovement with macroeconomic variables, both nominal and real. Combining financial shocks with conventional productivity and monetary shocks allows the model to reproduce the exchange rate disconnect properties without compromising the fit of the business cycle moments.
The real exchange rate (RER) measures relative price levels across countries, capturing deviations from purchasing power parity (PPP). RER is a key variable in international macroeconomic models as it is central to equilibrium conditions in both goods and asset markets. It is also one of the most starkly behaving variables empirically, tightly comoving with the nominal exchange rate and virtually uncorrelated with most other macroeconomic variables, nominal or real. This review lays out an equilibrium framework of RER determination, focusing separately on each building block and discussing corresponding empirical evidence. We emphasize home bias and incomplete pass-through into prices with expenditure switching and goods market clearing, imperfect international risk sharing, country budget constraint, and monetary policy regime. We show that RER is inherently a general equilibrium variable that depends on the full model structure and policy regime, and therefore partial theories like PPP are insufficient to explain it. We also discuss issues of stationarity and predictability of exchange rates.
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Government Policies in a Granular Global Economy
with Cecile Gaubert and Max Vogler
Carnegie-Rochester-NYU Public Policy Conference, March 2021
Journal of Monetary Economics, July 2021, Volume 121: 95-112
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We use the granular model of international trade developed in Gaubert and Itskhoki (2020) to study the rationale and implications of three types of government interventions typically targeted at large individual firms — antitrust, trade and industrial policies. We find that in antitrust regulation, governments face an incentive to be overly lenient in accepting mergers of large domestic firms, which acts akin to beggar-thy-neighbor trade policy in sectors with strong comparative advantage. In trade policy, targeting large individual foreign exporters rather than entire sectors is desirable from the point of view of a national government. Doing so minimizes the pass-through of import tariffs into domestic consumer prices, placing a greater portion of the burden on foreign producers. Finally, we show that subsidizing ‘national champions’ is generally suboptimal in closed economies as it leads to an excessive build-up of market power, but it may become unilaterally welfare improving in open economies. We contrast unilaterally optimal policies with the coordinated global optimal policy and emphasize the need for international policy cooperation in these domains.
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Granular Comparative Advantage
with Cecile Gaubert
Journal of Political Economy, March 2021, 129(3): 871–939
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Large firms play a pivotal role in international trade, shaping the export patterns of countries. We propose and quantify a granular multi-sector model of trade, which combines fundamental comparative advantage across sectors with granular comparative advantage embodied in outstanding individual firms. We develop an SMM-based estimation procedure, which takes full account of the general equilibrium of the model, to jointly estimate these fundamental and granular forces using French micro-data with information on firm domestic and export sales across manufacturing industries. We find that granularity accounts for about 20% of the variation in realized export intensity across sectors, and is more pronounced in the most export-intensive sectors. We then extend the model to a dynamic environment featuring both granular and fundamental shocks that jointly shape the time-series evolution of comparative advantage. We find a central role of granular forces in shaping comparative advantage reversals observed in the data.
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How strong are strategic complementarities in price setting across firms? In this article, we provide a direct empirical estimate of firms’ price responses to changes in competitor prices. We develop a general theoretical framework and an empirical identification strategy, taking advantage of a new micro-level dataset for the Belgian manufacturing sector. We find strong evidence of strategic complementarities, with a typical firm adjusting its price with an elasticity of 0.4 in response to its competitors’ price changes and with an elasticity of 0.6 in response to its own cost shocks. Furthermore, we find evidence of substantial heterogeneity in these elasticities across firms. Small firms exhibit no strategic complementarities in price setting and complete cost pass-through. In contrast, large firms exhibit strong strategic complementarities, responding to both competitor price changes and their own cost shocks with roughly equal elasticities of around 0.5. We show that this pattern of heterogeneity in markup variability across firms is important for explaining the aggregate markup response to international shocks and the observed low exchange rate pass-through into domestic prices.
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Is there a role for governments in emerging countries to accelerate economic development by intervening in product and factor markets? To address this question, we study optimal dynamic Ramsey policies in a standard growth model with financial frictions. The optimal policy intervention involves pro‐business policies like suppressed wages in early stages of the transition, resulting in higher entrepreneurial profits and faster wealth accumulation. This, in turn, relaxes borrowing constraints in the future, leading to higher labor productivity and wages. In the long run, optimal policy reverses sign and becomes pro‐worker. In a multi‐sector extension, optimal policy subsidizes sectors with a latent comparative advantage and, under certain circumstances, involves a depreciated real exchange rate. Our results provide an efficiency rationale, but also identify caveats, for many of the development policies actively pursued by dynamic emerging economies.
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The Macroeconomics of Border Taxes
with Omar Barbiero, Emmanuel Farhi and Gita Gopinath
NBER Macroeconomics Annual 2018, May 2019, Volume 33: 395-457
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We analyze the dynamic macroeconomic effects of border adjustment taxes (BAT), both when they are a feature of corporate tax reform (C-BAT) and for the case of value-added tax (VAT). Our analysis arrives at the following main conclusions. First, C-BAT is unlikely to be neutral at the macroeconomic level, as the conditions required for neutrality are unrealistic. The basis for neutrality of VAT is even weaker. Second, in response to the introduction of an unanticipated permanent C-BAT of 20% in the United States, the dollar appreciates strongly, by almost the size of the tax adjustment, and US exports and imports decline significantly, while the overall effect on output is small. Third, an equivalent change in VAT, in contrast to the C-BAT effect, generates only a weak appreciation of the dollar and a small decline in imports and exports, but has a large negative effect on output. Last, border taxes increase government revenues in periods of trade deficit; however, given the net foreign asset position of the United States, they result in a long-run loss of government revenues and an immediate net transfer to the rest of the world.
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Globalization, Inequality and Welfare
with Pol Antràs and Alonso de Gortari
Journal of International Economics, September 2017, 108: 387-412
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This paper studies the welfare implications of trade opening in a world in which trade raises aggregate income but also increases income inequality, and in which redistribution needs to occur via a distortionary income tax-transfer system. We provide tools to characterize and quantify the effects of trade opening on the distribution of disposable income (after redistribution). We propose two adjustments to standard measures of the welfare gains from trade: a ‘welfarist’ correction inspired by the Atkinson (1970) index of inequality, and a ‘costly-redistribution’ correction capturing the efficiency costs associated with the behavioral responses of agents to trade-induced shifts across marginal tax rates. We calibrate our model to the United States over the period 1979–2007 using data on the distribution of adjusted gross income in public samples of IRS tax returns, as well as CBO information on the tax liabilities and transfers received by agents at different percentiles of the U.S. income distribution. Our quantitative results suggest that both corrections are nonnegligible: trade-induced increases in inequality of disposable income erode about 20% of the gains from trade, while the gains from trade would be about 15% larger if redistribution was carried out via non-distortionary means.
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Trade and Inequality: From Theory to Estimation
with Elhanan Helpman, Marc Muendler and Steve Redding
Review of Economic Studies, January 2017, 84(1): 357-405
Reprinted: “Trade Liberalization” (2018, R. Wacziarg ed.; Edward Elgar publ.)
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While neoclassical theory emphasizes the impact of trade on wage inequality between occupations and sectors, more recent theories of firm heterogeneity point to the impact of trade on wage dispersion within occupations and sectors. Using linked employer–employee data for Brazil, we show that much of overall wage inequality arises within sector–occupations and for workers with similar observable characteristics; this within component is driven by wage dispersion between firms; and wage dispersion between firms is related to firm employment size and trade participation. We then extend the heterogenous-firm model of trade and inequality from Helpman et al. (2010) and estimate it with Brazilian data. We show that the estimated model provides a close approximation to the observed distribution of wages and employment. We use the estimated model to undertake counterfactuals, in which we find sizable effects of trade on wage inequality.
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Importers, Exporters and Exchange Rate Disconnect
with Mary Amiti and Jozef Konings
American Economic Review, July 2014, 104(7): 1942-78
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Large exporters are simultaneously large importers. We show that this pattern is key to understanding low aggregate exchange rate pass-through as well as the variation in pass-through across exporters. We develop a theoretical framework with variable markups and imported inputs, which predicts that firms with high import shares and high market shares have low exchange rate pass-through. We test and quantify the theoretical mechanism using Belgian firm-product-level data on imports and exports. Small nonimporting firms have nearly complete pass-through, while large import-intensive exporters have pass-through around 50 percent, with the marginal cost and markup channels contributing roughly equally.
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with Emmanuel Farhi and Gita Gopinath
Review of Economic Studies, April 2014, 81(2): 725-760
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We show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a dynamic New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions—producer or local currency pricing, along with nominal wage stickiness; under arbitrary degrees of asset market completeness and for general stochastic sequences of devaluations. There are two types of fiscal policies equivalent to an exchange rate devaluation—one, a uniform increase in import tariff and export subsidy, and two, a value-added tax increase and a uniform payroll tax reduction. When the devaluations are anticipated, these policies need to be supplemented with a consumption tax reduction and an income tax increase. These policies are revenue neutral. In certain cases equivalence requires, in addition, a partial default on foreign bond holders. We discuss the issues of implementation of these policies, in particular, under the circumstances of a currency union.
Trade Prices and the Global Trade Collapse of 2008-09
with Gita Gopinath and Brent Neiman
IMF Economic Review, September 2012, 60(3): 303-328
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The paper documents the behavior of trade prices during the Great Trade Collapse of 2008–09 using transaction-level data from the U.S. Bureau of Labor Statistics. First, the paper finds that differentiated manufactures exhibited marked stability in their trade prices during the large decline in their trade volumes. Prices of nondifferentiated manufactures, by contrast, declined sharply. Second, while the trade collapse was much steeper among differentiated durable manufacturers than among nondurables, prices in both categories barely changed. Third, the frequency and magnitude of price adjustments at the product level changed with the onset of the crisis, consistent with a state-dependent view of price adjustment. The quantitative magnitudes of the changes, however, were not pronounced enough to affect aggregate prices. The paper’s findings present a challenge for theories of the trade collapse based on cost shocks specific to traded goods that work through prices.
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Inequality and Unemployment in a Global Economy
with Elhanan Helpman and Steve Redding
Econometrica, July 2010, 78(4): 1239-1283
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This paper develops a new framework for examining the determinants of wage distributions that emphasizes within-industry reallocation, labor market frictions, and differences in workforce composition across firms. More productive firms pay higher wages and exporting increases the wage paid by a firm with a given productivity. The opening of trade enhances wage inequality and can either raise or reduce unemployment. While wage inequality is higher in a trade equilibrium than in autarky, gradual trade liberalization first increases and later decreases inequality.
Labour Market Rigidities, Trade and Unemployment
with Elhanan Helpman
Review of Economic Studies, July 2010, 77(3): 1100–1137
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We study a two-country, two-sector model of international trade in which one sector produces homogeneous products and the other produces differentiated products. Both sectors are subjected to search and matching frictions in the labour market and wage bargaining. As a result, some of the workers searching for jobs end up being unemployed. Countries are similar except for frictions in their labour markets, such as efficiency of matching and costs of posting vacancies, which can vary across the sectors. The differentiated-product industry has firm heterogeneity and monopolistic competition. We study the interaction of labour market rigidities and trade impediments in shaping welfare, trade flows, productivity, and unemployment. We show that both countries gain from trade. A country with relatively lower frictions in the differentiated-product industry exports differentiated products on net. A country benefits from lowering frictions in its differentiated sector’s labour market, but this harms the country’s trade partner. Alternatively, a simultaneous, proportional lowering of labour market frictions in the differentiated sectors of both countries benefits both of them. The opening to trade raises a country’s rate of unemployment if its relative labour market frictions in the differentiated sector are low, and it reduces the rate of unemployment if its relative labour market frictions in the differentiated sector are high. Cross-country differences in rates of unemployment exhibit rich patterns. In particular, lower labour market frictions do not ensure lower unemployment, and unemployment and welfare can both rise in response to falling labour market frictions and falling trade costs.
Frequency of Price Adjustment and Pass-through
with Gita Gopinath
Quarterly Journal of Economics, May 2010, 125(2): 675-727
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We empirically document, using U.S. import prices, that on average goods with a high frequency of price adjustment have a long-run pass-through that is at least twice as high as that of low-frequency adjusters. We show theoretically that this relationship should follow because variable mark-ups that reduce longrun pass-through also reduce the curvature of the profit function when expressed as a function of cost shocks, making the firm less willing to adjust its price. We quantitatively evaluate a dynamic menu-cost model and show that the variable mark-up channel can generate significant variation in frequency, equivalent to 37% of the observed variation in the data. On the other hand, the standard workhorse model with constant elasticity of demand and Calvo or state-dependent pricing has difficulty matching the facts.
Currency Choice and Exchange Rate Pass-through
with Gita Gopinath and Roberto Rigobon
American Economic Review, March 2010, 100 (1): 304-336
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We show, using novel data on currency and prices for US imports, that even conditional on a price change, there is a large difference in the exchange rate pass-through of the average good priced in dollars (25 percent) versus nondollars (95 percent). We document this to be the case across countries and within disaggregated sectors. This finding contradicts the assumption in an important class of models that the currency of pricing is exogenous. We present a model of endogenous currency choice in a dynamic price setting environment and show that the predictions of the model are strongly supported by the data.
