Effects of price stickiness on conditional exchange rate pass-through in Iran: A DSGE approach

Exchange rate pass-through is one of the important issues in the macroeconomics literature. A change in exchange rate represents a change in relative prices and so the allocation of resources in society will be affected and the competitiveness of domestically manufactured goods in world markets will be changed. The price stickiness is the main factor affecting exchange rate pass-through (ERPT). If prices are sticky, with a change in exchange rate, firms do not transfer all of this change to prices and they change their profit margin.
In contrast to earlier studies for Iran, where exchange rate pass-through is treated as an unconditional phenomenon, our analyses are made conditional on the structural shocks. An important issue which has been take lots of consideration is that exchange rate pass-through conditional on each shock is different from another shock and policy makers should take this issue into consideration. The shock which has caused movement in exchange rate has an important role in how exchange rate is passed through prices. For the analysis of exchange rate pass-through conditional on each shock (technology Shock, oil revenues, foreign demand, money demand, foreign interest rate and monetary policy), a dynamic stochastic general equilibrium (DSGE) model for Iran is developed. The model includes a monopolistic competition and price stickiness. The economy consists of households, monetary authorities, government, firms including a final-good producer, intermediate-goods producer, importing firms and oil sector. The final products, used in consumption and investment, are produced by competitive firms. Competitive firms use domestic and foreign intermediate goods as inputs. Intermediate-goods producers are monopolistically competitive firms that use capital and labor as inputs. Domestic intermediate goods are also exported to the other countries of the world. Foreign intermediate goods are imported by monopolistically competitive importing firms at world prices. Then these goods are sold to domestic final producers at domestic currency. Prices which set by monopolistic firms are costly to changes and therefore prices are stickiness. This is the cause which in short time exchange rate pass -through is incomplete.
Using DSGE model for calculating conditional exchange rate pass through has several advantages. First, and most importantly, it takes into account the fact that prices and the nominal exchange rate are simultaneously determined. Second, because our model is structural, the analysis can be made conditional on the shocks. Exchange rate pass-through conditional on each shock is derived by the ratio of the covariance of impulse response of price and exchange rate to the variance of impulse response of exchange rate for every period then the patterns are showed graphically. Aggregate pass-through to import prices for each period which is equal to the sum of conditional pass-through coefficients in each time weighted by the contribution of each shock is also computed.
Results show that conditional exchange rate pass-through in Iran is incomplete and the degree of exchange rate pass-through conditional on each shock is different from another shock and after 20 quarters it reaches to 40 to 70 percentages. Also a test for analyzing the importance of price rigidity in exchange rate pass-through is performed. The results show that the higher the degree of price stickiness, the lower the degree of conditional exchange rate pass-through will be. One of the reasons why exchange rate pass-through is high in Iran is low degree of price stickiness. Importing firms are limited in Iran and they aren’t competitive firms and when a shock occurs, without the fear of losing the market share, they change the prices.