Oxford Research Encyclopedia of Economics and Finance is now available via subscription and perpetual access. Visit About to learn more, meet the editorial board, or learn how to subscribe.

Dismiss
Show Summary Details

Page of

PRINTED FROM the OXFORD RESEARCH ENCYCLOPEDIA, ECONOMICS AND FINANCE (oxfordre.com/economics). (c) Oxford University Press USA, 2020. All Rights Reserved. Personal use only; commercial use is strictly prohibited (for details see Privacy Policy and Legal Notice).

date: 28 September 2020

International Prices and Exchange Rate Pass-Through

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.

Keywords: exchange rate pass-through, import prices, export prices, consumer prices, currency choice, nominal rigidities

Key Findings and Issues

Movements in exchange rates can often be sudden and large. There is much interest in examining how prices, especially import and consumer prices, respond to changes in the exchange rate. One popular measure of the degree of price response of a basket of goods is exchange rate pass-through, which is defined as the elasticity of the home-currency price of the basket with respect to the exchange rate (an increase representing an appreciation of the foreign currency). The dynamic version defines pass-through in the short and long run as price elasticities over short and long periods. There is a large literature on estimating pass-through to a variety of prices for a wide range of countries and time periods. One key finding is that pass-through to import prices is incomplete (the pass-through value is less than one) in the short and even in the long run. Another important result is that pass-through to consumer prices is smaller than import price pass-through and is generally very low. Pass-through to export prices tends to be between import and consumer price pass-through.

Incomplete import price pass-through implies that home prices of imported goods do not change in proportion to the exchange rate change, and thus prices of foreign goods at home would deviate from their prices abroad (in the same currency), contrary to the law of one price, which says that identical goods should have the same price everywhere (after adjusting for trade barriers). Early literature emphasized the role of pricing to market (price discrimination) and market segmentation under imperfect competition in explaining incomplete pass-through (Goldberg & Knetter, 1997). Recent models have highlighted the importance of nominal rigidities in explaining incomplete pass-through as well as other pass-through evidence. Another strand in the recent literature explains the pass-through evidence using models where a firm’s markup is variable and responds to exchange rate changes.

The pass-through literature addresses a number of issues that have important policy implications. In models with nominal rigidities, one major question is whether exporting firms set prices in the currency of their country (producer’s currency) or the importing country’s currency (consumer’s currency). If prices are set in producer’s currency and changed infrequently, flexible exchange rates are beneficial as they allow for desirable relative price adjustment. On the other hand, if prices are sticky in consumer’s currency, exchange rate flexibility confers no such benefit and a case can be made for the superiority of fixed exchange rates. The standard model with pure producer or consumer currency pricing (same currency choice for all firms at home and abroad) and a constant markup, however, is not compatible with typical pass-through estimates for import and export prices. To explain this evidence, two approaches have emerged, which modify the standard model in different directions. One approach assumes a hybrid model of currency choice where some firms set prices in producer’s and others in consumer’s currency. The other approach allows markup to vary in response to exchange rate changes.

Another important issue that has received much attention is whether inflationary environment can affect pass-through, especially to consumer prices. Theoretical models suggest several channels through which inflationary environment can influence pass-through to import and consumer prices. Empirical evidence shows that pass-through to consumer price is related to the level and variability of inflation across countries and time periods, and thus supports the view that monetary policy—which is primarily responsible for inflationary environment—plays an important role in determining consumer price pass-through.

One advantage associated with low pass-through is that it dampens inflationary consequences of a depreciation of home currency. A potential disadvantage of low pass-through, on the other hand, is that the unresponsiveness of prices to exchange rate changes would impede adjustment of relative prices and the balance of trade. General equilibrium analysis of this potential concern suggests that while shocks driving the exchange rate weaken the effect on trade volumes, they strengthen the effect on the exchange rate. The two effects tend to offset each other and the value of pass-through does not make much difference to the overall effect on trade balance adjustment.

The rest of the article is organized as follows. It begins with a discussion of the methodologies used for estimating pass-through to different prices and notes the limitations of different methodologies. This discussion is followed by a summary of the basic results of the empirical work on pass-through. Explanations of pass-through evidence for import and export prices in terms of nominal rigidities, currency choice, and variable markup are discussed next. The review then goes on to examine two issues: the relationship between inflationary environment and pass-through, and the implications of pass-through for the effectiveness of monetary policy and the adjustment of trade balance. Finally, the key policy implications of the pass-through literature are summarized.

Estimating Exchange Rate Pass-Through

There is extensive research concerned with estimating exchange rate pass-through to a range of prices. The primary focus of this research has been on estimating pass-through to prices of traded goods (traded prices) at the aggregate as well as the disaggregate level. The standard estimation methodology is based on a regression model, which has a similar form for different levels of aggregation. The model is typically estimated for prices of aggregate imports or exports. For period t, let PM,t denote the price index for overall imports of a country expressed in home currency, and let St be the nominal exchange rate (number of home currency units per unit of foreign currency). Using lower-case letters to denote values in logs, the regression model for estimating the exchange rate pass-through to aggregate import price can be expressed as

ΔpM,t=c+aΔst+bvt+et,

where ΔpM,t is the proportional change in the import price index, Δst is the proportional change in the exchange rate, vt is a vector of variables used to control for other effects, and c and et represent the constant and error terms.

This relation can be motivated by the price setting mechanism in a monopolistically competitive industry. Import prices set by foreign firms represent a markup over foreign costs. The primary control variable is change in foreign costs, which is usually proxied by the foreign inflation rate. GDP growth in the home country is often used as an additional control variable. An important extension of the model allows for nominal rigidities, which imply that prices adjust gradually to changes in the exchange rate and other variables. In this case, the control vector would generally include lagged values of all variables including the exchange rate variable. A typical specification for the effect of controls is

bvt=i=1n1b1iΔsti+i=0n2b2iΔpti*+i=0n3b3iΔyti,

where pt* is the log of foreign country’s Consumer Price Index (CPI), yt is the log of home GDP, and lags are allowed to differ across variables. In the regression with lags, the effect of the exchange rate on prices is spread over multiple periods. Conditional on other variables, the exchange rate pass-through equals a in the short run (in the same period) and equals a+i=1n1b1i in the long run. A similar regression model can be specified for pass-through to export prices in home currency. As export prices set by domestic firms are a markup over domestic costs, the typical controls for the export price regression would include contemporaneous and lagged values of home inflation rate and foreign GDP growth (as well as lagged values of exchange rate changes).

There is also considerable interest in exploring how exchange rate changes affect consumer prices. The consumption bundle consists of imported goods and domestic goods consumed at home. Domestic goods for home consumption include local distribution services (e.g., transportation and retailing) and processing of imported inputs at home. The inflation rate (the log change in CPI) can be expressed as

Δpt=αΔpM,t+(1α)ΔpD,t,

where α is the share of imported goods and pD,t represents the log of the price index for domestic goods. If prices of domestic goods were not affected by exchange rate changes, the pass-through to the consumer price index would simply equal the import price pass-through multiplied by the share,α. In general, however, exchange rate changes would influence domestic goods prices, and this effect would also be included in pass-through to CPI. Pass-through to CPI has also been estimated using regression models. The specification of the regression equation, however, differs across studies as there is no consensus on what controls to use for domestic goods prices.

As the pass-through regressions do not include all potential controls and proxies are used for the controls that are included, estimates are subject to bias due to omitted variables and measurement errors. Note, moreover, that exchange rate changes are not exogenous, but are driven by a variety of shocks. These shocks can also influence control variables, which are also determined endogenously. Thus, a limitation of pass-through estimates conditional on controls is that they do not capture the indirect effect of shocks driving the exchange rate, operating via the controls. The indirect effect in the short run may be small if the shocks that dominate the short-run variation of the exchange rate do not have a significant short-run impact on controls (e.g., inflation rate and GDP growth). The indirect effect in the medium and long run, however, is likely to be more important.

An alternative methodology addresses the endogeneity issue by using a vector auto-regression (VAR) model to estimate exchange rate pass-through. Another appeal of this methodology is that it can use the same model to estimate pass-through to not only traded prices but also consumer prices. A basic VAR model (with n lags) for estimating pass-through can be expressed as

zt=c+B1zt1+B2zt2+...+Bnztn+et,

where zt=[Δst,ΔpM,t,ΔpX,t,Δpt,Δpt*], pX,t denotes the export price index in logs, and et is a vector of innovations (reduced-form shocks). This model could be extended to include additional variables (e.g., log changes of home and foreign GDP). In the VAR model, n-period pass-through to traded and consumer prices can be estimated as the accumulated response of log changes in the import price index, the export price index, and CPI after n period to the structural shock to the exchange rate (the short-run pass-through would represent the response in period 1). The VAR model, however, does not provide direct estimates of structural shocks, and they need to be related to the vector of innovations in order to identify them. With Δst as the first variable in the VAR, the exchange rate innovation, e1,t, generally depends on the structural exchange rate shock as well as other structural shocks. It can be argued that e1,t essentially captures the exchange rate shock as it is not affected much by other shocks. In this case, exchange rate pass-through can be estimated as the response of prices to the exchange rate innovation. These estimates, however, are sensitive to the underlying assumption that the exchange rate shock dominates e1,t. If other shocks are considered to have significant influence on e1,t, an alternative scheme is needed to identify the exchange rate shock. But it is not clear what assumptions (restrictions on the matrix relating structural to reduced form shocks) would yield a satisfactory identification of structural shocks.

Yet another estimation methodology is based on using dynamic stochastic general equilibrium (DSGE) models. Impulse response functions in a DSGE model provide the dynamic response of various prices to each shock. In the new Keynesian DSGE models for open economies, interest rate parity relation plays an important role in the short-run determination of the exchange rate. The shock to this relation can be viewed as the exchange rate shock. Estimates of exchange rate pass-through to import and export prices as well as CPI can then be obtained from the dynamic response of these prices to the exchange rate shock. Although this approach has strong theoretical foundations, the estimation procedure is clearly sensitive to the structure of the model.

Basic Results

Estimates of exchange rate pass-through to traded and consumer prices based on regression models are available from a large number of studies, which cover a wide range of countries and periods. Pass-through estimates are available for individual prices as well as aggregate price indexes. The pass-through to import prices tends to be significantly different from both zero and one in the short as well as the long run. For a broad set of OECD countries, Campa and Goldberg (2005) find that the pass-through to import prices is, on average, 0.46 in the short run, and 0.64 in the long run. Estimates for export price pass-through are generally lower than import price pass-through, but are still significantly above zero (see, e.g., Choudhri & Hakura, 2015). The result that export price pass-through is smaller than import price pass-through has the interesting implication that an increase in the exchange rate (home currency depreciation) would worsen the terms of trade (the ratio of export to import price index). The pass-through to CPI is often found to be low and close to zero in the short run and not much higher over long periods. Choudhri and Hakura (2006), for example, estimate the average CPI pass-through for a large set of low-inflation countries to be 0.04 in the same quarter and 0.20 after 20 quarters. CPI is a weighted average of prices of imported and domestic goods. The domestic goods component of CPI includes distribution margins for foreign consumption goods as well as value-added margins for local processing of foreign inputs. Pass-through to CPI can be smaller than import price pass-through and low because of the weaker responsiveness of the domestic component of CPI to the exchange rate (see, e.g., Campa & Goldberg (2010), who examine the exchange rate sensitivity of different components of CPI for 21 OECD countries).

Estimates of pass-through to import, export, and consumer prices have also been obtained from VAR models (the use of this methodology goes back to McCarthy (2007)). Interestingly, estimates of short- and medium-term pass-through derived from VAR models are not much different from estimates based on regression models. For example, Choudhri, Faruqee, & Hakura (2005) show that VAR estimates of the average import price pass-through for non-U.S. G7 countries is 0.45 in the short run (quarter 1) and 0.73 in the medium run (quarter 4). The corresponding short- and medium-run values are 0.25 and 0.36 for export price pass-through and 0.2 and 0.11 for CPI pass-through.

Pass-through to both traded and consumer prices varies considerably across countries. For pass-through to traded prices, estimates for the United States are outliers as they tend to be relatively low for both import and export prices. There is also some evidence that pass-through to consumer as well as traded prices have decreased since the 1990s. There is much interest in exploring the sources of inter-country and inter-periods variation in pass-through. Several explanations of these variations have emerged and are discussed in the section “Inflationary Environment and Pass-Through.”

Nominal Rigidities, Currency Choice, and Pass-Through

There has been much debate about what mechanism determines exchange rate pass-through to import and export prices. An important issue is the role played by nominal rigidities and currency choice in the setting of the prices of imports and exports. Currency choice for price setting has important implications for the international transmission mechanism and the design of monetary policy in an open economy. The conventional assumption—incorporated in the popular Mundell–Fleming model and adopted by Obstfeld and Rogoff’s (1995) seminal contribution to new open economy macroeconomics—is that traded prices are sticky in the currency of the producer. Models based on the assumption of producer currency pricing (PCP) imply that flexible exchange rates are desirable in achieving needed adjustment of relative price as advocated by Friedman (1953) and others. An alternative view (e.g., Betts & Devereux, 2000) assumes that traded prices are sticky in the currency of local consumers. The assumption of local currency pricing (LCP) leads to very different prescriptions for exchange rate policy. For example, Devereux and Engel (2003) show that under LCP, there is no benefit to exchange rate flexibility and fixed exchange rates are to be preferred. The two currency choices also imply different optimal monetary policy rules. Under PCP, the optimal rule is inward looking: it stabilizes domestic variables (home inflation and output) and does not react to international variables such as the exchange rate (Clarida, Gali, & Gertler, 2002; Corsetti & Pesenti, 2001). Under LCP, the optimal rule would react to international variables (Corsetti & Pesenti, 2005).

There is considerable interest in examining how the PCP and LCP hypotheses fare in explaining the evidence on pass-through. In the basic version of price stickiness where price is preset for one period, both hypotheses imply extreme values of pass-through, which are inconsistent with the evidence. In this case, for example, PCP implies that the pass-through equals one for import prices as foreign firms would keep their price fixed in their currency and prices in home currency would increase in the same proportion as the exchange rate. For export prices, on the other hand, PCP implies a pass-through equal to zero. These implications are reversed under LCP: the pass-through to import prices equals zero while the pass-through to export prices equals one. A more realistic model of price stickiness that allows a firm’s price to be kept unchanged for multiple periods would allow pass-through to traded prices to be incomplete (i.e., have a value between zero and one) under both PCP and LCP, but would not change these values sufficiently to conform to the pass-through evidence. One popular model of nominal rigidities is the Calvo (1983) mechanism of staggered prices, in which a firm faces a probability θ that it would change its price (export price set in home currency under PCP and foreign currency under LCP) in each period. Thus, the probability that a firm’s price would remain unchanged in the period equals 1θ, and it can be shown that the average length of time over which the firm’s price would remain fixed equals 1/θ. The value of θ can be chosen based on the evidence on frequency of price changes. This mechanism can be incorporated in the standard monopolistic competition model with a constant markup (arising from the conventional assumption of constant elasticity preferences) to derive values of pass-through to traded prices predicted by PCP and LCP. General equilibrium models with these features yield pass-through values for both hypotheses that are either too large or too small relative to typical estimates (see, e.g., Choudhri & Hakura, 2006, Figure 4). An additional problem for LCP (noted by Obstfeld & Rogoff, 2000) is its implication that a depreciation of home currency would be associated with an improvement in the terms of trade (because pass-through to export prices is larger than that to import prices), which is inconsistent with the evidence.

Two approaches have emerged to reconcile theoretical predictions with the pass-through evidence. One approach modifies the standard model to allow markup to adjust in response to exchange rate changes. Markup adjustment can be introduced in a number of ways. One way is to assume that the sale of traded goods to consumers requires an input of local (non-traded) distribution services. Under this assumption, Corsetti and Dedola (2005) show that even with symmetric and constant elasticity preferences, the elasticity of demand (for traded goods producers) is country specific and a function of the exchange rate. Thus, variation in markup (as demand elasticity changes) dampens the response of traded prices to the exchange rate and leads to incomplete pass-through even in the presence of flexible prices (in which case, currency choice does not matter). Corsetti, Dedola, and Leduc (2008) use this setup in a DSGE model to demonstrate that LCP combined with a low degree of nominal rigidity can generate empirically reasonable values of pass-through to import prices and the association between exchange rate changes and the terms of trade observed in data. Another way to allow markup adjustment is to assume preferences that imply demand functions with non-constant price elasticity. Gust, Leduc, and Vigfusson (2010) assume a demand aggregator that makes the demand elasticity a function of a firm’s price relative to its competitors’ price. This feature induces a firm to reduce its markup in response to an exchange rate increase and thus can account for incomplete pass-through even under flexible prices.

An alternative approach to explaining the pass-through evidence assumes that there is a mix of firms using PCP and LCP in each economy. This assumption is consistent with data on the currency of invoicing of exports and imports (see, e.g., Goldberg & Tille, 2008), which show that international transactions are invoiced in national currency as well as trading partner’s currency or a vehicle currency such as the U.S. dollar, and the share of national currency invoicing varies across countries and industries. A hybrid model with both PCP and LCP yields pass-through values for traded prices that lie between the predictions of models with only PCP or only LCP, and the model is capable of explaining the evidence on pass-through without a markup adjustment mechanism. Choudhri and Hakura (2006) show that a DSGE model with staggered prices, a constant markup, and a reasonable mix of PCP and LCP can account for the average values of pass-through elasticities for import and export prices as well as other features of the data for advanced countries. Moreover, this model can explain the similarity of estimates obtained from regressions and VARs. A hybrid model with both PCP and LCP is also found to help explain the degree of exchange rate pass-through to various prices in non-U.S. G6 countries (Choudhri et al., 2005).

The PCP–LCP mix for the home country can be different from the foreign country mix. The United States represents a special case where PCP is mainly used for exports while LCP is largely used for imports. Gopinath and Rigobon (2008), for example, report that 90% of U.S. imports and 97% of U.S. exports are priced in dollars. This asymmetric currency choice can explain why U.S. pass-through is low for both import and export prices. Dollar invoicing of U.S. imports and exports also implies that a dollar depreciation would have asymmetric effects on trade flows between the United States and its trading partners (Goldberg & Tille, 2006). The U.S. dollar is used in invoicing not only U.S. imports and exports, but also trade flows between non-U.S. countries. Goldberg and Tille (2009) explore the monetary policy implications of the U.S. dollar as the dominant currency of invoicing. Using a simple center–periphery model, they show that the special position of the U.S. dollar magnifies the impact of U.S. monetary policy on real variables in the rest of the world. The model also implies that optimal monetary policy in the United States would be different than in non-U.S. countries and there would be gains from monetary policy cooperation.

The literature on optimal currency choice suggests that the use of both PCP and LCP (for exporting firms) in an economy can arise under two types of equilibria. One possibility is an equilibrium where firms using PCP and LCP are indifferent between the two types of pricing (Devereux, Engel, & Storegaard, 2004). Another possibility is that PCP is preferred for one type of products while LCP is preferred for others (Bacchetta & van Wincoop, 2005). Using disaggregated data for U.S. imports, Gopinath, Itskhoki, and Rigobon (2010) find that homogeneous goods are largely priced in dollars (non-U.S. firms use LCP) while a larger share of differentiated goods are priced in other currencies (PCP used by non-U.S. firms). They also show that average pass-through for goods priced in dollars is much smaller than for goods priced in non-dollars. They develop an endogenous model of currency choice that is consistent with the evidence presented here.

Inflationary Environment and Pass-Through

An important issue that has received considerable attention is whether monetary policy can affect pass-through, especially to consumer prices. Monetary policy plays an important role in determining the inflationary environment that can influence pass-through via several channels. One channel emphasized by Taylor (2000) is the effect on the persistence of cost changes. In a model with LCP where foreign firms change import prices infrequently, price response to exchange rate changes would be stronger if the effect on costs is perceived to be more persistent. Regimes with higher inflation tend to have more persistent exchange rate and cost changes and thus would lead to higher pass-through to import and hence to consumer prices. Another channel operates via the effect on the frequency of price change. There is some evidence that prices are changed more frequently in economies with higher inflation. Devereux and Yetman (2010) develop a theoretical explanation of this relationship by letting frequency of price change in the Calvo model (determined by parameter θ) be determined endogenously: each firm chooses the price change frequency (taking the frequency of other firms’ price change as given) to minimize an appropriate loss function. They use a calibrated model to show that under endogenous determination of the frequency of price adjustment, pass-through to import and consumer prices is increasing in average inflation, but at a declining rate. Yet another potential channel works through the effect on the proportion of firms using LCP. Higher inflation can increase the pass-through if it induces some foreign firms to shift from LCP to PCP.

One test of the link between inflation and pass-through is provided by the evidence on cross-sectional variation across countries. Choudhri and Hakura (2006) use data for about two decades to obtain regression estimates of pass-through to consumer prices for a large number of countries. They then use second-stage regression to show that pass-through (in both the short and long run) is positively and significantly related to indexes of inflation and exchange rate variability across countries. These results are further supported by evidence from Devereux and Yetman (2010), who use data for a longer period and a wider set of countries to first estimate country-specific pass-through and then use second-stage regression to relate these estimates to measures of average inflation and variability of inflation and exchange rates. They also find evidence of non-linearity in the relation between pass-through and average inflation, which matches the prediction of their model with endogenous price change frequency.

Inter-period variation can provide an additional test of the effect of inflation on pass-through. Since the 1980s, many industrial countries have pursued monetary policies (using explicit or implicit monetary policy rules) to achieve lower and more stable inflation rates. There has been much interest in examining whether this shift in the inflationary environment led to a decline in pass-through. Gagnon and Ihrig (2004) use the inflation data from 1971 to 2003 for 20 industrial countries to identify a shift in the regime (from high to low inflation) during each country’s sample. They find that the long-run pass-through to consumer prices estimated for the second subsample (after the shift) was lower for nearly every country than the pass-through for the first subsample (before the shift). The average pass-through declined from 0.16 in the first to 0.05 in the second subsample. Further evidence supporting the hypothesis that the pass-through declines in response to a shift to a low and stable inflationary regime is provided by Bailliu and Fujii (2004), who use panel data for a smaller set of countries to show that regime breaks in the 1990s decreased pass-through to consumer as well as import and producer prices.

Other factors could also have contributed to the pass-through decline in the period since the 1990s. One potential factor is the decrease in trade costs during this period. Gust et al. (2010) argue that increased trade integration in this period accounted for a significant portion of the decline in pass-through. They illustrate this effect by developing a dynamic general equilibrium model with variable elasticity demand functions where the elasticity depends on a firm’s price relative to the price of its competitors. In this model, lower per-unit trade costs (or higher productivity) allows a foreign firm to increase its relative markup over costs, which induces it to vary its markup more and its price less in response to an exchange rate movement, and thus lower pass-through as a result of greater trade integration.

Pass-Through, Monetary Policy, and Trade Balance

The exchange rate represents an important channel for the transmission of the effects of monetary policy. An exchange rate depreciation, for example, would lower the relative price of home to foreign goods, and thus stimulate economic activity by switching expenditures from foreign to home goods. An important concern with a low pass-through environment is that the unresponsiveness of trade prices to exchange rate changes would dampen the expenditure switching effect and weaken the effectiveness of monetary policy. Low pass-through to traded prices could also slow down the adjustment of the balance of trade and make it difficult to achieve external balance.

Letting QX,t and QM,t denote quantities of exports and imports, nominal trade balance (in home currency) equals TBt=PX,tQX,tPM,tQM,t. To see how the balance of trade is linked to the exchange rate, express it as

TBt=StPM,t*[(PX,t/PM,t)QX,tQM,t],

where PM,t* is the import price index expressed in foreign currency (so that StPM,t*=PM,t). A low pass-through to trade prices could dampen the effect of a given change in the exchange rate on trade balance (operating via possible weak effect on the terms of trade as well as on volumes of exports and imports, which are a function of the terms of trade). However, exchange rate changes are determined endogenously and need not be the same across different pass-through regimes. Thus, it is important to also examine how exchange rate changes (for a given set of shocks) would vary across low and high pass-through regimes.

Gust, Leduc, and Sheets (2009) use a dynamic general equilibrium model to explore the implications of pass-through to trade prices for the adjustment of trade balance. Their model includes features—LCP, distribution services, variable demand elasticity—that can account for incomplete and low pass-through. They find that while a low pass-through regime weakens the response of trade volumes to various shocks (i.e., shocks to government spending, monetary expansion, and technology), it strengthens the exchange rate response to these shocks. Indeed, for reasonable estimates of the elasticity of substitution between home and foreign goods, the two effects tend to offset each other and pass-through does not play an important role in determining the degree of adjustment in the nominal balance of trade.

Policy Implications

Pass-through literature has highlighted several policy issues. One key issue is the desirability of fixed versus flexible exchange rates. The welfare effects of the two regimes depend on the currency choice for price setting. Under PCP and sticky prices, flexible exchange rates are more desirable as they allow needed adjustment of relative prices of home to foreign goods. These advantages are lost under LCP and sticky prices, in which case fixed exchange rates are preferable. Welfare comparisons between flexible and fixed exchange rate are unambiguous in the pure cases where all home and foreign firms either use PCP or LCP. However, estimates of pass-through to trade prices and evidence on currency invoicing suggest the prevalence of mixed cases where both PCP and LCP are used by home and foreign firms. An asymmetry can also occur in the currency choice between home and foreign firms as in the special case of the United States, where U.S. firms mainly use PCP while non-U.S. firms largely use LCP. In these mixed cases, the welfare gap between the fixed and flexible exchange rates is likely to be small, and the gap may be further reduced if currency for price setting is chosen by firms and is thus endogenous.

Another important issue is the link between pass-through and inflation. An environment with low pass-through to import and consumer prices insulates an economy from the inflationary consequences of home currency depreciation and makes it easier for monetary policy to pursue independent inflation targets. Pass-through environment, however, may not be independent of monetary policy. Indeed, pass-through evidence suggests that nominal rigidities (price change frequency, currency choice) play an important role in determining pass-through values and are influenced by monetary policy. A monetary policy regime that is successful in achieving low and stable inflation would lead to a low pass-through environment via low price change frequency and shifts in PCP–LCP mix. This effect would, in fact, facilitate the implementation of a low inflation policy.

Although a low pass-through environment mutes the effect of exchange rate changes on trade prices, one potential concern is that lack of relative price response would weaken the effect on volumes of exports and imports and thus impede the adjustment of the balance of trade. Analysis of this issue in a general equilibrium framework suggests that while shocks to the economy exert a weaker effect on trade volumes in a low pass-through environment, the effect on trade balance through this channel tends to be offset by the stronger impact of shocks on the exchange rate. Thus, the overall magnitude of trade balance adjustment may not be much different between low and high pass-through settings.

Further Reading

Gopinath, G. (2016). The international price system. Jackson Hole symposium proceedings. NBER Digest, January.Find this resource:

References

Bacchetta, P., & van Wincoop, E. (2005). A theory of the currency denomination of international trade. Journal of International Economics, 67(2), 295–319.Find this resource:

Bailliu, J., & Fujii, E. (2004). Exchange rate pass-through and the inflation environment in industrialized countries: An empirical investigation. Bank of Canada Working Paper No. 2004–21.Find this resource:

Betts, C., & Devereux, M. (2000). Exchange rate dynamics in a model of pricing to market. Journal of International Economics, 50, 215–244.Find this resource:

Calvo, G. A. (1983). Staggered prices in a utility-maximizing framework. Journal of Monetary Economics, 12(3), 383–398.Find this resource:

Campa, J. M., & Goldberg, L. S. (2005). Exchange rate pass-through into import prices. Review of Economics and Statistics, 87(4), 679–690.Find this resource:

Campa, J. M., & Goldberg, L. S. (2010). The sensitivity of the CPI to exchange rates: Distribution margins, imported inputs, and trade exposure. Review of Economics and Statistics, 92(2), 392–407.Find this resource:

Choudhri, E. U., Faruqee, H., & Hakura, D. S. (2005). Explaining the exchange rate pass-through in different prices. Journal of International Economics, 65, 349–374.Find this resource:

Choudhri, E. U., & Hakura, D. S. (2006). Exchange rate pass-through to domestic prices: Does the inflationary environment matter? Journal of International Money and Finance, 25, 614–639.Find this resource:

Choudhri, E. U., & Hakura, D. S. (2015). The exchange rate pass-through to import and export prices: The role of nominal rigidities and currency choice. Journal of International Money and Finance, 51, 1–25.Find this resource:

Clarida, R., Gali, J., & Gertler, M. (2002). A simple framework for international policy analysis. Journal of Monetary Economics, 49, 879–904.Find this resource:

Corsetti, G., & Dedola, L. (2005). A macroeconomic model of international price discrimination. Journal of International Economics, 67, 129–156.Find this resource:

Corsetti, G., Dedola, L., & Leduc, S. (2008). High exchange-rate volatility and low pass-through in business cycle models. Journal of Monetary Economics, 55, 1113–1128.Find this resource:

Corsetti, G., & Pesenti, P. (2001). Welfare and macroeconomic interdependence. Quarterly Journal of Economics, 116, 421–446.Find this resource:

Corsetti, G., & Pesenti, P. (2005). International dimension of optimal monetary policy. Journal of Monetary Economics, 52, 281–305.Find this resource:

Devereux, M. B., & Engel, C. (2003). Monetary policy in open economy revisited: Price setting and exchange rate flexibility. Review of Economic Studies, 70, 765–783.Find this resource:

Devereux, M. B., Engel, C., & Storegaard, P. (2004). Endogenous exchange rate pass-through when nominal prices are set in advance. Journal of International Economics, 63(2), 263–291.Find this resource:

Devereux, M. B., & Yetman, J. (2010). Price adjustment and exchange rate pass-through. Journal of International Money and Finance, 29(1), 181–200.Find this resource:

Friedman, M. (1953). The case for flexible exchange rates. In Essays in Positive Economics (pp. 157–203). Chicago, IL: University of Chicago Press.Find this resource:

Gagnon, J. E., & Ihrig, J. (2004). Monetary policy and exchange rate pass-through. International Journal of Finance and Economics, 9, 315–338.Find this resource:

Goldberg, L. S., & Tille, C. (2006). The international role of the dollar and trade balance adjustment. Group of Thirty Occasional Paper No. 71.Find this resource:

Goldberg, L. S., & Tille, C. (2008). Vehicle currency use in international trade. Journal of International Economics, 76, 177–192.Find this resource:

Goldberg, L. S., & Tille, C. (2009). Macroeconomic interdependence and the international role of the dollar. Journal of Monetary Economics, 56(7), 990–1003.Find this resource:

Goldberg, P. K., & Knetter, M. M. (1997). Goods prices and exchange rates: What have we learned? Journal of Economic Literature, 35, 1243–1292.Find this resource:

Gopinath, G., Itskhoki, O., & Rigobon, R. (2010). Currency choice and exchange rate pass-through. American Economic Review, 100(1), 304–306.Find this resource:

Gopinath, G., & Rigobon, R. (2008). Sticky borders. Quarterly Journal of Economics, 123(2), 531–575.Find this resource:

Gust, C., Leduc, S., & Sheets, N. (2009). The adjustment of global external balance: Does partial exchange rate pass-through to trade prices matter? Journal of International Economics, 79(2), 173–185.Find this resource:

Gust, C., Leduc, S., & Vigfusson, R. (2010). Trade integration, competition, and the decline in exchange rate pass-through. Journal of Monetary Economics, 57(3), 309–324.Find this resource:

McCarthy, J. (2007). Pass-through of exchange rates and import prices to domestic inflation in some industrialized economies. Eastern Economic Journal, 33(4), 511–537.Find this resource:

Obstfeld, M., & Rogoff, K. (1995). Exchange rate dynamics redux. Journal of Political Economy, 102, 624–660.Find this resource:

Obstfeld, M., & Rogoff, K. (2000). New directions for stochastic open economy models. Journal of International Economics, 50, 117–154.Find this resource:

Taylor, J. (2000). Low inflation, pass-through, and pricing power of firms. European Economic Review, 44(7), 1389–1408.Find this resource: