RDP 9304: Exchange Rate Pass-Through: The Different Responses of Importers and Exporters 3. The Analytical Framework

The starting point for analysis of exchange rate pass-through is ‘the law of one price’.^[6] In its absolute form, the law of one price states that the price of a traded good will be the same in both the domestic and foreign economies, when expressed in a common currency. The law can be expressed as follows:

where: P is the domestic price of the traded good; P^* is the corresponding foreign price; and e is the exchange rate in units of domestic currency per unit of foreign currency (so that an increase in e indicates depreciation).^[7]

Departures from the law of one price occur when, for a given foreign price of a traded good, changes in its domestic price are not proportional to changes in the exchange rate. A departure from the law of one price, therefore, implies that exchange rate pass-through is incomplete. The pass-through relationship can be expressed most simply as:

where: ˆ denotes the proportional change. Clearly, if foreign prices do not change, equals and pass-through is complete. Alternatively, if foreign prices do not change but is less than , there has been a departure from the law of one price and pass-through is incomplete.

However, this representation of exchange rate pass-through implicitly assumes perfect competition. If the assumption of perfect competition is relaxed, an allowance can be made for variations in the profit margins of price setting agents (Mann 1986; Hooper and Mann 1989). The price of a traded good can now be defined as the sum of the costs of producing the good (c) and a margin (m). For example:

so that,

Thus it can be shown that the change in the domestic price of a traded good will be related not only to the exchange rate, but to the pricing policies of foreign agents. In this case, foreign suppliers may act to offset the effects of depreciation by lowering their margins so that exchange rate pass-through is incomplete.

In fact, as argued by Hooper and Mann (1989), presentation of the pass-through relationship should allow for the variation of margins of both domestic and foreign price setting agents. This permits the following expression:

When the issue of margins is introduced, it is apparent that exchange rate pass-through occurs in two stages. In the first stage, foreign price-setting agents will choose either to maintain or change their margins in response to depreciation. In the second stage, local distributors will, in turn, choose to maintain or change their margins when setting the price that they charge local customers. Thus, in an environment of imperfect competition, the final impact of an exchange rate depreciation on consumer prices is determined by the extent of combined pass-through.

The extent of exchange rate pass-through is governed by three main factors: the relative elasticities of demand for and supply of traded goods, macroeconomic conditions and the microeconomic environment (Phillips 1988).

First, in the absence of other shocks, the relative price elasticities of demand and supply are the principal determinants of exchange rate pass-through. For exports, the degree of pass-through will increase the greater is the elasticity of demand and the smaller is the elasticity of supply. Conversely, for imports, the degree of pass-through will increase the lower is the elasticity of demand and the greater is the elasticity of supply (Spitäller 1980; Bureau of Industry Economics 1987). From this it follows that pass-through will be complete in the case of a small open economy. In such a case, exporters are assumed to face perfect elasticity of demand while importers face perfect elasticity of supply, so that the country is a price taker in world markets.^[8]

Second, macroeconomic shocks may operate either to reinforce or counteract the influence of demand and supply elasticities. For instance, when domestic demand is buoyant or capacity is constrained, the extent of exchange rate pass-through for imports is likely to be high irrespective of the relative elasticities of demand and supply (Piggot and Reinhart 1985; Phillips 1988). Alternatively, when domestic demand is weak or capacity utilisation is low, the margins of foreign suppliers may be squeezed so that pass-through for imports is incomplete. Again, this may occur irrespective of elasticities of demand and supply.^[9] In fact, firms may face a macroeconomic shock of sufficient magnitude to generate a permanent change in the volume of goods traded and the degree of pass-through (Baldwin 1988; Dixit 1989).^[10]

Third, at the level of individual industries, the microeconomic environment will influence the strategies of price setting agents. When homogenous products are traded in an integrated world market, arbitrage eliminates differentials in the common currency price of goods. However, when markets are imperfectly competitive and segmented, a wide range of pricing responses is possible.^[11] For example, if agents have power as price makers and seek to maximise profit, exchange rate pass-through is likely to be high regardless of other factors (Phillips 1988). Alternatively, if agents seek to maximise market share rather than profit, pass-through may be incomplete (Hooper and Mann 1989; Ohno 1990). Furthermore, if opportunities exist to discriminate between markets, ‘pricing to market’ may occur, yielding different degrees of pass-through across a range of segmented markets (Krugman 1986; Gagnon and Knetter 1992). Finally, pricing strategies will be influenced by expectations about future currency price movements and the length of the corporate planning horizon (Froot and Klemperer 1988; Ohno 1990).

There is now an established body of empirical literature on exchange rate pass-through, most of which focuses on the American experience.^[12] A body of Australian empirical literature has also emerged, largely in response to the price effects of currency movements in the mid to late 1980s. Australian studies have been almost entirely confined to the analysis of import price pass-through.^[13]

It is timely to examine the responses of both importers and exporters to the latest episode of currency depreciation in Australia. In fact, Australia provides a test of the small country case. It is expected, a priori, that pass-through will be complete in the long run for imports and exports of manufactures. However, observed pricing behaviour suggests that, in the short run, pass-through will be incomplete.

Equation (1) forms the basis of a simple model for testing exchange rate pass-through. It is applied to both imports and exports of Australian manufactures. However, before discussing its functional form and the estimation technique to be adopted, consider the data required to test the pass-through relationship.

Footnotes

See Menon (1991a) for a comprehensive discussion of the relationship between the law of one price and exchange rate pass-through. [6]

In its relative form, the law allows for a wedge factor of transactions costs (k) and can be expressed as . However, if k is constant, both the relative and absolute forms of the law of one price will be equivalent when expressed in log linear form or in proportional changes. [7]

Specifically, when exporters face perfectly elastic demand, following a change in the exchange rate, the domestic price of the export must not deviate from the foreign price when expressed in common currency. This requires the domestic price of the export to move in exact proportion to the exchange rate: hence, pass-through will be complete. Importers, on the other hand, face perfect elasticity of supply. Since foreigners will not adjust the foreign currency price of the good following a change in the exchange rate, the domestic price of the import will move in exact proportion to the exchange rate: again, pass-through will be complete. [8]

That is, assuming such elasticities are neither infinite nor zero. [9]

This possibility is most often considered with respect to large changes in the exchange rate. However, such shocks may also include domestic demand (Menzies and Heenan 1993). [10]

Phillips (1988) explores the microeconomic aspects of pass-through. [11]

Menon (1992a) provides an extensive review of the international literature. [12]

Amongst the few examples of export price pass-through are those by Menon (1991b) and Heath (1991). [13]