Modeling Exchange Rate Passthrough After Large Devaluations∗

Large devaluations are generally associated with large declines in real exchange rates. Burstein, Eichenbaum, and Rebelo (2005) argue that the primary force causing these declines is often the slow adjustment in the price of nontradable goods and services. We develop a model which embodies two complementary forces that account for the large declines in the real exchange rate that occur in the aftermath of large devaluations. The first force is sticky nontradable goods prices. Instead of simply assuming that nontradable goods prices are sticky, we develop conditions under which this phenomenon can emerge as an equilibrium outcome. The second force is the impact of real shocks that often accompany large devaluations. These real shocks lead to a decline in the price of nontradable goods relative to traded goods. We argue that sticky nontradable goods prices generally play an important role in explaining post-devaluation movements in real exchange rates. However, there are cases in which sticky nontradable goods prices are not sustainable as an equilibrium phenomenon. In these cases real shocks are the primary driver of real exchange rate movements. J.E.L. Classification: F31 ∗We thank Miles Kimball for his suggestions, and Pierpaolo Benigno, Mario Crucini, Andy Levin, Carlos Vegh, Ivan Werning, and Mike Woodford for their comments. We gratefully acknowledge financial support from the National Science Foundation. †UCLA. ‡Northwestern University, NBER and Federal Reserve of Chicago. §Northwestern University, NBER and CEPR.