Journal of International Economics 50 (2000) 215–244 www.elsevier.nl / locate / econbase Exchange rate dynamics in a model of pricing-to-market a b ,c , * Caroline Betts , Michael B. Devereux a Department of Economics, University of Southern California, Los Angeles, CA 90089, USA b Faculty of Business Administration, Chinese University of Hong Kong, Hong Kong c Department of Economics, University of British Columbia, 997-1873 East Mall, Vancouver, BC, Canada V6T 1Z1 Received 20 March 1997; received in revised form 2 February 1998; accepted 16 March 1998 Abstract This paper develops a general equilibrium exchange rate model consistent with the weak empirical evidence supporting the law of one price. Some firms segment markets by country, and set prices in local currency of sale, a practice we refer to as pricing-to-market (PTM). The presence of PTM increases exchange rate volatility, relative to a situation where the law of one price holds. PTM also affects the international transmission of monetary and fiscal policy. The higher is the degree of PTM, the lower is the comovement in consumption across countries, but the higher is the comovement in output. In terms of welfare, monetary policy is a ‘‘beggar-thy-neighbor’’ instrument in the presence of a high degree of PTM.  2000 Elsevier Science B.V. All rights reserved. Keywords: Pricing-to-market; Exchange rates; Purchasing power parity JEL classification: F3; F4 1. Introduction This paper develops a simple exchange rate model which combines international market segmentation by imperfectly competitive firms and local currency price- setting. We refer to this as a situation of ‘‘pricing-to-market’’ (PTM). We find that * Corresponding author. Fax: 11-604-822-5915. E-mail address: devm@unixg.ubc.ca (M.B. Devereux) 0022-1996 / 00 / $ – see front matter  2000 Elsevier Science B.V. All rights reserved. PII: S0022-1996(98)00036-1