Exchange-rate models face trilemma matching trade, prices, markups

A new working paper identifies a fundamental trilemma in two-country DSGE models. These models struggle to simultaneously match producer markups, muted expenditure switching, and low exchange-rate pass-through.

The core parameterization challenge

A new working paper from the Federal Reserve Bank of Philadelphia, authored by Lukasz A. Drozd, Marcin Kolasa, and Jaromir B. Nosal, evaluates several leading microfounded pricing-to-market (PTM) mechanisms within a two-country DSGE model.

The study identifies a 'fundamental parameterization trilemma' where models struggle to simultaneously match empirically plausible producer markups, muted expenditure switching (low short-run trade elasticity), and the low exchange-rate pass-through needed for business-cycle dynamics.

This tension arises because jointly achieving low exchange-rate pass-through to import prices and muted expenditure switching is crucial for matching international business-cycle moments.

The research examines various theories of incomplete pass-through, including the Distribution Cost, Price Dispersion, Nested CES Aggregation, Deep Habits, and Customer Capital models, alongside the reduced-form Kimball aggregator.

The authors emphasize that their analysis abstracts from nominal frictions, viewing limited pass-through as largely a real phenomenon.

Varied performance across frameworks

The study reveals varied performance across models.

The reduced-form Kimball aggregator (KA) struggles with business-cycle quantity statistics, failing to reconcile plausible markups with low short-run trade elasticity.

This issue extends to microfounded models, where demand schedule manipulation is often insufficient.

The Nested CES Aggregation (NCES) model excels in price statistics but is not suited for general-equilibrium applications.

The Deep Habits model performs well on quantities but implies more-than-complete pass-through.

Search models offer the best balance for prices and quantities, though at the cost of introducing harder-to-identify frictions.

The authors conclude that while higher markup targets could mitigate the trilemma, empirically justifying values above 70% remains challenging.

The inherent model trade-off

This research reveals a core tension in international macro models, limiting their ability to fully capture real-world exchange-rate dynamics.

The identified trilemma forces difficult trade-offs, often sacrificing empirical realism in one area for another.

New theoretical approaches are urgently needed to integrate pricing-to-market robustly with broader business-cycle phenomena.