Intermediate goods trade and exchange rate pass-through

For a small open economy characterized by intermediate goods trade, exchange rate changes affect not only the relative price of domestic consumption goods to foreign consumption goods, but also the relative price of local input to imported intermediate goods in the trade sector. Therefore, the adjustment role of a flexible exchange rate as an efficient mechanism in face of external shocks will be subject to the degree of exchange rate pass-through to both imported consumption goods and intermediate goods. In this paper, we develop a small open economy model with intermediate goods trade to investigate the implication of exchange rate pass-through to input prices for economic dynamics and the desirability of flexible exchange rates. Our model shows that in the presence of either terms of trade shocks or non-traded productivity shocks, the degree of exchange rate pass-through to input prices affects the economy more than does the degree of pass-through to goods prices. Furthermore, we find that, compared with the full exchange rate pass-through case, a delayed pass-through to input prices leads to more welfare loss than does a delayed pass-through to goods prices.