Summary and Keywords
Exchange rates often display sudden and large changes. There is considerable interest in examining how these changes affect prices, especially import and consumer prices. Exchange rate pass-through measures the responsiveness of the price of a basket of goods to changes in the exchange rate and is defined as the elasticity of the price of the basket (expressed in home currency) with respect to the exchange rate (defined as the price of foreign currency). The pass-through estimates vary across product groups, countries, and time periods, but a general finding is that pass-through tends to be significantly less than one, which implies that prices do not fully respond to a foreign currency appreciation. Pass-through to export prices tends to be smaller than pass-through to import prices. Pass-through to consumer prices is lower than both import and export price pass-through and is generally very small. One explanation of pass-through evidence focuses on the role of nominal rigidities (infrequent changes in prices set in home or foreign currency). Another explanation emphasizes the importance of markup variation in response to exchange rate changes.
In models with nominal rigidities, one important issue is whether exporting firms set prices in their country’s currency (producer’s currency) or importing country’s currency (consumer’s currency). If prices are sticky in producer’s currency, flexible exchange rates are preferable as they allow for desirable relative price adjustment. On the other hand, if prices are sticky in consumer’s currency, exchange rate flexibility is not as helpful in adjusting prices and fixed exchange rates are superior. The standard model where markup is constant and all firms (at home and abroad) use either producer or consumer currency pricing is not consistent with typical estimates of pass-through to import and export prices. To explain this evidence, the standard model needs to be modified to allow for variable markup and/or a hybrid model of currency choice where some firms set prices in producer’s and others in consumer’s currency. In the case of the hybrid model, the welfare difference between fixed and flexible exchange rates is not as stark as in the pure cases of currency choice and is likely to be small. Another issue of much interest is whether inflationary environment can affect pass-through, especially to consumer prices. Inflationary environment can influence pass-through to import and consumer prices through several channels, such as persistence of costs and frequency of price change. Empirical evidence shows that pass-through to consumer prices is related to the level and variability of inflation across countries and time periods and is lower in an environment with low and stable inflation. This evidence suggests that a monetary policy regime that targets low inflation will produce a low pass-through environment, which would dampen the price effects of exchange rate changes.
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