In this paper we argue that the primary force behind the large drop in real exchange rates that occurs after large devaluations is the slow adjustment in the prices of nontradable goods and services. Our empirical analysis uses data from five large devaluation episodes: Argentina (2002), Brazil (1999), Korea (1997), Mexico (1994), and Thailand (1997). We conduct a detailed analysis of the Argentinian case using disaggregated consumer price index data, data from our own survey of prices in Buenos Aires, and scanner data from supermarkets. We assess the robustness of our findings by studying large real exchange rate appreciations, medium devaluations, and small exchange rate movements.

We present a model embodying moderate amounts of nominal rigidities that accounts for the observed inertia in inflation and persistence in output. The key features of our model are those that prevent a sharp rise in marginal costs after an expansionary shock to monetary policy. Of these features, the most important are staggered wage contracts that have an average duration of three quarters and variable capital utilization.