International Pricing in New Open-Economy Models

R ecent developments in open-economy macroeconomics have progressed under the paradigm of nominal price rigidities, where monetary disturbances are the main source of fluctuations. Following developments in closed-economy models, new open-economy models have combined price rigidities and market imperfections in a fully microfounded intertemporal general equilibrium setup. This framework has been used extensively to study the properties of the international transmission of shocks, as well as the welfare implications of alternative monetary and exchange rate policies. Imperfect competition is a key feature of the new open-economy framework. Because agents have some degree of monopoly power instead of being price takers, this framework allows the explicit analysis of pricing decisions. The two polar cases for pricing decisions are producer-currency pricing and local-currency pricing. The first case is the traditional approach, which assumes that prices are preset in the currency of the seller. In this case, prices of imported goods change proportionally with unexpected changes in the nominal exchange rate, and the law of one price always holds.1 In contrast, under the assumption of local-currency pricing, prices are preset in the buyer’s currency. Here, unexpected movements in the nominal exchange rate do not affect the price of imported goods and lead to short-run deviations from the law of one price.