Exchange rate dynamics in a model of pricing-to-market

This paper develops a general equilibrium exchange rate model consistent with the weak empirical evidence supporting the law of one price. Some firms segment markets by country, and set prices in local currency of sale, a practice we refer to as pricing-to-market (PTM). The presence of PTM increases exchange rate volatility, relative to a situation where the law of one price holds. PTM also affects the international transmission of monetary and fiscal policy. The higher is the degree of PTM, the lower is the comovement in consumption across countries, but the higher is the comovement in output. In terms of welfare, monetary policy is a "beggar-thy-neighbor" instrument in the presence of a high degree of PTM. (C) 2000 Elsevier Science B.V. All rights reserved.