Abstract
In this paper we develop a linear rational expectations equilibrium model of staggered import contracts with incomplete exchange rate indexing to explain the slow and moderate adjustment of import prices and quantities to exchange rate changes. The existence and stability of the equilibrium are proved by establishing equivalence between the solution to the equilibrium problem and the solution of an optimal linear regulator problem. Simulation analysis illustrates that the nature of the adjustment of import prices and quantities to exchange rate changes depends crucially on the length of the contract and the length of the delivery lag. Thus, an alternative to the ‘hysteresis’ explanation of the slow and moderate adjustment of import prices and quantities to exchange rate changes is established. The new explanation, however, has significantly different implications for exchange rate management and trade policies.
Published Version
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