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The Journal of Development Studies

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Exchange Rate Pass-Through in Developing and


Emerging Markets: A Survey of Conceptual,
Methodological and Policy Issues, and Selected
Empirical Findings

Janine Aron, Ronald Macdonald & John Muellbauer

To cite this article: Janine Aron, Ronald Macdonald & John Muellbauer (2014) Exchange Rate
Pass-Through in Developing and Emerging Markets: A Survey of Conceptual, Methodological
and Policy Issues, and Selected Empirical Findings, The Journal of Development Studies, 50:1,
101-143, DOI: 10.1080/00220388.2013.847180

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The Journal of Development Studies, 2014
Vol. 50, No. 1, 101143, http://dx.doi.org/10.1080/00220388.2013.847180

Exchange Rate Pass-Through in Developing and


Emerging Markets: A Survey of Conceptual,
Methodological and Policy Issues, and Selected
Empirical Findings
JANINE ARON*, RONALD MACDONALD** & JOHN MUELLBAUER*,
*Institute for New Economic Thinking at the Oxford Martin School, University of Oxford, Oxford, UK, **Department of
Economics, Adam Smith Building, University of Glasgow, Glasgow, UK, Nuffield College, University of Oxford, and Institute
for New Economic Thinking at the Oxford Martin School, University of Oxford, Oxford, UK

Final version received August 2013

ABSTRACT Global integration has increased the international linkages of financial markets for emerging market
countries. A key channel for the international transmission of inflation and economic cycles is from exchange rate
movements to domestic prices, known as exchange rate pass-through (ERPT). This article reviews the conceptual,
methodological and policy issues connected with ERPT in emerging market and developing countries, and
critically surveys selected empirical studies. A key contribution is to categorise and compare the heterogeneous
methodologies used to extract ERPT measures in the empirical literature. Single equation models and systems
methods are contrasted; frequent misspecifications that produce unreliable ERPT estimates are highlighted. The
discerning policy-maker needs to ascertain by which methods ERPT measures were calculated, the controls and
restrictions applied, and the time frame and stability of the estimates.

1. The Changing Focus of the Exchange Rate Pass-Through Literature


This article provides an overview of the literature on exchange rate pass-through (ERPT) to prices (the
effect of exchange rate changes on domestic prices). The focus is the burgeoning empirical research on
ERPT for emerging market and developing economies, and on the global as well as local monetary
policy relevance of ERPT. For instance, the strategic pricing practices of emerging market exporters1
breaking into new markets has been implicated in lowering global inflation (Figure 1).
By the late 1990s, there was a sizeable empirical literature on ERPT, mainly for the industrialised
countries (Goldberg & Knetter, 1997; Menon, 1995).2 Early research had a micro-economic focus
from the industrial organisation literature, analysing the pricing strategies of monopolistic firms with
industry-level and product-level trade price data, and ERPT to aggregate trade prices. The focus of the
literature has since changed: volatility in exchange rates and persistent trade imbalances globally, have
galvanised interest in the role of ERPT in monetary policy. The New Open Economy
Macroeconomics (for example, Obstfeld, 2002) provided a theoretical catalyst for empirical macro-
economic research on the ERPT, and the Taylor (2000) staggered pricing model added a further

Correspondence Address: Janine Aron, Institute for New Economic Thinking at the Oxford Martin School, University of Oxford,
Oxford, UK. Email: janine.aron@economics.ox.ac.uk
An Online Appendix is available for this article which can be accessed via the online version of this journal available at
http://dx.doi.org/10.1080/00220388.2013.847180

2014 Taylor & Francis


102 J. Aron et al.

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impetus. These empirical models have investigated the delayed and incomplete ERPT, and the
apparent decline in ERPT in some countries since the 1980s, for aggregate import prices and domestic
consumer price indices. Taylor argues that the ERPT is itself influenced by the monetary policy regime
(see Section 2).
At the research frontier, coming full circle from aggregate indices back to disaggregated data, is a
new focus on price adjustment and heterogeneous ERPT, using the millions of prices that underlie the
aggregate consumer and producer price indices. This approach has centred on industrialised countries,
given the paucity of data sets (Klenow & Malin, 2011); the first emerging market study for ERPT is
published in this special section (Aron, Creamer, Muellbauer, & Rankin, 2014).
Faced with a plethora of reported ERPT measures in the empirical literature, the discerning policy-
maker needs to ascertain by which method these were calculated, which controls and restrictions were
applied, and the time frame and stability of the estimates. Reported ERPT estimates from different
methodologies are not directly comparable, as the underlying assumptions differ. A key contribution of
this article is to categorise and compare the heterogeneous methodologies used to extract ERPT
measures. Single equation models and systems methods are contrasted; and frequent misspecifications
that produce unreliable ERPT estimates in empirical applications are highlighted.
The original definition of ERPT referred to the percentage change in import prices in domestic
currency in response to a 1 per cent change in the exchange rate3 (now called Stage 1 ERPT). The
definition has since been extended to address the effect of exchange rate movements on producer or
consumer prices (Overall ERPT). The effect of a change in import prices on producer or consumer
prices is known as Stage 2 ERPT. The time dimension is important: a distinction needs to be made
between very long-run or equilibrium measures of ERPT and measures over a shorter period of one
or two years, considered most relevant for monetary policy.
Typically the sensitivity to the exchange rate will decline down the price distribution chain, from
import prices at the dock in the destination country, through wholesale and retail networks to final
consumer prices. However, even for at the dock import prices, ERPT may be incomplete if exchange
rate changes elicit a less than equi-proportionate change in prices. It is helpful to distinguish between
the pricing strategies considered in the theoretical models of the new open-economy macroeco-
nomics. In producer currency pricing (PCP), prices are set and are sticky in the exporters currency.4
Then ERPT to import prices is complete: variations in the exchange rate leave the exporters prices in
their own currency unchanged, while destination market prices vary closely with the exchange rate.
Exchange Rate Pass-Through in Developing and Emerging Markets 103

However, considerable empirical evidence suggests the opposite: ERPT is incomplete, exporters
prices vary closely with the exchange rate and the local (destination) prices remain fairly stable.
This is known as local currency pricing (LCP). Goldberg and Hellerstein (2008) suggest it is the
convention in the literature that incomplete pass-through refers to a single-destination market and
pricing-to-market (PTM) to multiple-destination markets with market segmentation. Both generate
deviations from the law of one price.
With complete or near complete ERPT to import prices and perhaps producer prices, a flexible
exchange rate adjusts the trade balance through expenditure switching (for example, the flight from
quality) towards locally produced substitutes, when imported goods become more expensive with
destination currency depreciation. Provided that the ERPT is then incomplete to the retail or final
goods prices, the gains in competitiveness will not be entirely inflated away (Obstfeld, 2002).
Unsurprisingly, therefore, firms pricing behaviour and the ultimate ERPT to different prices are
crucial in the policy debate on optimal monetary and exchange rate regimes (Section 2).
What can explain the pervasive findings of delayed and incomplete ERPT? Three possible channels
are suggested by theory for generating incomplete ERPT, and much micro-empirical literature has
been devoted to adjudicating amongst them (see Goldberg & Hellerstein, 2008). The destination
countrys import price at the point of entry is defined as the exporters price divided by the (bilateral)
exchange rate (Section 3). The exporters price is determined by the exporters marginal cost in own
currency multiplied by a mark-up over the marginal cost. Thus, incomplete ERPT where the
exporters price varies closely with the variation in the exchange rate could be due to a change in
the mark-up (which we call Channel 1) and/or a change in the marginal cost (Channel 2). There is also
a third factor: delayed (and hence incomplete in the short run) ERPT could be due to nominal rigidities
that cause unresponsiveness in prices in the short run (Channel 3); for example, firms paying a menu
cost will adjust prices less frequently.5 In the very short run there is little change in the destination
currency import price.
A common misconception noted by Goldberg and Hellerstein (2008) is that incomplete ERPT
reflects the degree of competition in the destination market. In perfectly competitive markets, where
goods are homogeneous and the price equals marginal cost (there is no mark-up), the ERPT will be
complete, or else firms will suffer a loss and have to exit the market. With imperfect competition, firms
can charge a mark-up on costs, but there will be an effect on ERPT only if mark-ups are not constant
but variable.6 Since, from the first order condition for the firms profit maximisation problem the
firms mark-up is determined by the price elasticity of demand, the functional form of the demand
curve7 matters for Channel 1 of ERPT.8 Also relevant for this channel (and related to the shape of
demand curves) are two other factors that influence the firms mark-up: the ease of substitutability
between similar domestic and foreign goods; and the degree of market segmentation. The lower is the
substitutability (that is, the greater the product differentiation) and the greater the market segmentation
(so arbitrage is limited even for the same good), the greater will be the market power of price-setting
firms. These general points for the distribution of imports apply as much to an imperfectly competitive
retail sector, where distributors can absorb part of the exchange rate fluctuations to maintain stable
prices or expand market share, leading to what Hellerstein and Goldberg call a double margin-
alisation. Menon (1995) further explores the implications for ERPT from the industrial organisation
literature of different market structures and behavioural assumptions of firms, for example using the
Cournot oligopoly model of Dornbusch (1987).9
Mark-up variation, however, cannot fully explain the extent of exporters price adjustment (see the
evidence from micro-studies in Section 7). The exchange rate must therefore also impact marginal
costs (Channel 2). Examples are where there are decreasing returns to scale in production of the
exporters good (for example, due to short-run capacity constraints);10 imported inputs into the
exporters good; and/or local non-traded costs in the destination market (costs of distribution and
wholesale/retail such as transport, taxes, tariffs, storage, marketing, advertising, finance, insurance,
real wages and rents). Goldberg and Hellerstein (2008) observe that local non-traded costs generate
different (incomplete) ERPT in different destination markets (that is, PTM), whereas the former two
examples imply an incomplete ERPT that is the same over different markets. Local costs are
104 J. Aron et al.

unresponsive to exchange rate fluctuations: where (non-traded) local services comprise a high propor-
tion of marginal costs, even large changes in imported costs may not affect local prices much. In
practice, Channel 2 appears to be the biggest contributor to generating incomplete ERPT through
imported inputs and/or local costs (Section 7).
Turning to Channel 3, price rigidity and other dynamic factors could contribute to incomplete
ERPT, at least in the short run. The price stickiness found in micro-studies is insufficient to account for
the slow adjustment of aggregate prices (Rogoff, 1996). Klenow and Malin (2011) argue that a
contract multiplier is required to explain why real effects of nominal shocks appear to last several
years, and potential multipliers include strategic complementarities, countercyclical mark-ups, sticky
plans, and sticky information (including rational inattention, for example Reis [2006]). The direct link
between inflation and exchange rate changes is then obscured.
Other factors also blur the linkage between inflation and exchange rate changes. If consumers
switch from imported goods to lower-quality, cheaper local brands, the ERPT will register as
incomplete; these quality adjustments are often not properly measured in the consumer price index
(Burstein, Neves, & Rebelo, 2003). The stage of the business cycle may influence exporters pricing
decisions; for example, if there are production constraints in a boom, this could raise ERPT. A volatile
macro-economic environment also affects ERPT, whether induced by external commodity price
shocks, waning confidence in macro-management, or greater global risk aversion. These factors
could all induce foreign exchange rate volatility, which in emerging markets with poor hedging
opportunities is typically associated with a rise in ERPT as exporters price in their own more stable
currency (though there are other possibilities, see Froot & Klemperer [1989]). Finally, the central
banks reaction function should be modelled in a system with the ERPT model, as we argue below,
since the exchange rate is endogenous to policy with sometimes substantial feedback effects from
monetary policy. For example, an inflation-targeting central bank would raise interest rates to head off
inflation induced by an exchange rate shock, so correcting part of the initial exchange rate
depreciation.
The standard models assume ERPT is linear (in logs of prices and the exchange rate), but recent
research has investigated asymmetries in price responses to exchange rate fluctuations (for example,
Bussire, 2007; Marazzi & Sheets, 2007; Pollard & Coughlin, 2003). There are potentially directional
asymmetries, where depreciation may elicit a different proportionate price response than appreciation,
and/or size asymmetries, where smaller changes may produce a different proportionate response to
larger changes. The former may arise from strategic considerations11 and downward price rigidities.12
Size asymmetries may result from menu costs associated with changing prices: firms absorb small
exchange rate changes in their margins and only pass through to prices those changes exceeding a size
threshold (Channel 3).
Finally, much literature investigates a different non-linearity: apparent secular declines in ERPT
with structural/regime changes.13 Possible micro-explanations include the metamorphosis of the
trading basket from homogeneous raw materials (with rapid price adjustment) towards differentiated
manufactured goods and services (Campa & Goldberg, 2005); or the changing geographical composi-
tion of trading partners (for example, Chinese imports lowering the United States ERPT, Marazzi and
Sheets [2007]). The key macro-explanation is the adoption of transparent and stable monetary regimes,
a la Taylor (2000) (see Section 2.2; for example, Gagnon and Ihrig [2004], for the United States
consumer price index).14
Until comparatively recently, few analyses have tested the above hypotheses for trade prices and
domestic prices in emerging market15 and developing countries. These small, open and trade-
dependent economies embody special features that can make it difficult to obtain reliable estimates
of ERPT. Where the exchange rate has been actively targeted, for example in Asia, systems
methods with feedback effects may be more reliable than single equation models. With extensive
structural transformations, for example in South Africa (SA) and Central and Eastern European
countries in the 1990s, shifts in ERPT should be tested for. The greater uncertainty facing
economic agents also raises the relevance of non-linearities from threshold effects (menu, hedging
Exchange Rate Pass-Through in Developing and Emerging Markets 105

and other transactions costs). Finally, hyperinflation and macro-volatility make for challenging
empirical analysis.
The survey first summarises links between monetary policy and ERPT. Section 3 gives the
theoretical underpinning of the partial equilibrium ERPT model that underlies most empirical studies.
Section 4 critically compares different methodologies used to extract ERPT measures, and Section 5
raises important data issues. Section 6 examines and tabulates selected empirical evidence for emer-
ging market countries using aggregate price data; and Section 7 reviews micro-based research. The
survey concludes in Section 8.

2. Monetary Policy and Exchange Rate Pass-Through


Pinning down the ERPT mechanisms at different points in the price distribution chain, and hence
deriving the ultimate implications for consumer price inflation and economic activity, is key to
effective monetary policy-making. The degree and delay of ERPT also influences the effectiveness
of trade balance adjustment through expenditure switching, and hence choice of the exchange rate
regime. Two different theoretical contributions have spawned a host of empirical testing that links
ERPT and monetary policy. In Section 2.1, the sometimes controversial expenditure-switching role
of the exchange rate in the new open macroeconomic (NOE) models is explored with different
pricing assumptions for firms. Increasing trade integration, shifts in market structure and in the
weights of consumer price index (CPI) components might all be reasons for a decline in EPRT. In
Section 2.2, the Taylor hypothesis is presented with its rationale for the decline in ERPT under
credible monetary policy regimes.

2.1. Incomplete Pass-Through and NOE Models


The NOE models (for example, Obstfeld & Rogoff, 2000) allow for wage and price stickiness in fully
specified dynamic general-equilibrium models, thereby introducing microeconomic optimisation into macro-
economic models. The assumptions made regarding the degree of ERPT critically influence the effectiveness
of monetary policy. In some models ERPT is complete because PCP is assumed. Such models are contra-
dicted, however, by the empirical evidence against complete ERPT and against the purchasing parity theory
of exchange rates implied by PCP. In other variants of the NOE, pricing to market is combined with local
currency pricing (LCP). Then the exchange rate no longer has the standard expenditure-switching role,
which, in turn, has potentially important implications for the choice of exchange rate regime. However, there
are several arguments that undermine the extreme LCP assumption and reinstate a role for the exchange rate
as an expenditure-switching device. We review some of the key contributions.
Engel (1999) and others claim for industrial countries that the volatility of CPI-based real exchange
rates is almost totally driven by the nominal exchange rate rather than movements in the relative price
of non-traded goods (that is, ERPT to CPI is almost zero). One interpretation is that exporters combine
pricing-to-market with LCP. In this case, exporters preset export prices in the buyers currency and
satisfy demand at the posted local currency prices in the short run. As Obstfeld (2002) notes, in this
class of model the policy implications are drastic, since the exchange rate has no expenditure-
switching role to alter the relative prices that agents face. Since the exchange rate cannot alter relative
consumer spending, exchange rates are as well to be fixed, since the unintended volatility from a
flexible rate is likely to be harmful to economic welfare in other areas of the economy (in trade and
investment, for example). In this class of model, therefore, overall welfare is maximised when the
exchange rate is fixed. Fixed or pegged exchange rates have important implications for the monetary
policy regime. For instance, monetary policy directed at maintaining an exchange rate peg will
generally differ from inflation targeting with floating rates.
However, Obstfeld (2002) points out that the LCP models miss at least two key aspects of reality.
First, import prices at the point of entry to a country in practice respond differently to shocks than do
the prices underlying the CPI. Therefore, the kind of regularities that researchers such as Engel have
observed in CPI-based real exchange rates may have little bearing on import price behaviour. Second,
106 J. Aron et al.

it may be firms rather than consumers which are central to the expenditure-switching effect of the
exchange rate and respond to relative price changes, even if consumers do not. If so, it will be import
prices at the point of entry that will influence economic decisions. This will be particularly relevant
should the firm have multinational operations, since then the critical price for expenditure switching
will be the real exchange rate measured with respect to relative unit labour costs.
Aside from theoretical distinctions, there are practical reasons why the extreme LCP assumption is
wanting. Although it seems neatly to explain the observed behaviour of CPI-based real exchange rates,
prices at earlier stages of importation behave differently from CPI prices. One important factor driving
a wedge between import prices and final consumer prices is local non-traded costs in the destination
market (see Burstein et al., 2003). These reduce the weights on border prices for imports in consumer
price indexes. A second point, often overlooked in the literature, relates to the constituents of the
aggregate CPI itself. A substantial proportion of the index consists of service items that are not linked
with imports, such as housing costs and expenditure on domestic services (for example, home
insurance). Rich countries have higher CPI weights on such non-traded services than poor countries,
so that this alone would account for lower ERPT to consumer prices in rich countries.
A high degree of trade integration particularly through multinational companies can also account for
a relatively low ERPT to CPI. Since such companies produce and trade both intermediate and final
goods, exchange rate changes can affect decisions about the production of final goods both directly
and indirectly through changes to input prices. Distributing production over many countries means the
price will be a function of several different currency movements some favourable and some
unfavourable (in other words, a diversification effect is achieved with respect to exchange rate
movements). As Menon (1995, pp. 204206) points out, intra-firm transactions within a large multi-
national often occur using internal exchange rates insulated from market rates. After a depreciation
shock, a subsidiary with access to intra-firm credit would be better able to continue to sell at pre-
depreciation prices than a small independent firm.
Additionally, and as a result of globalisation, the emergence of large importers with significant
market power that can discriminate between suppliers based in different locations can affect pass-
through. For such players it is optimal to switch to more favourably priced suppliers as exchange rates
change, thereby reducing the need to change the destination import price as the exchange rate changes.
Obstfeld draws parallels between the elasticity pessimism of the historical trade literature and the
illusion that ERPT could be almost zero: both were based on poor statistical analysis (see Section 3).
The final nail in the coffin of the extreme LCP hypothesis is perhaps the evidence on actual invoicing
practices of countries. Empirical evidence on actual invoicing practices of countries cited by Obstfeld
(2002) suggests that, with the exception of the United States, imports are more often invoiced in
foreign currencies rather than local currencies.16
2.2. Declining ERPT and the Taylor Hypothesis
Many attribute the causes of low inflation during the great moderation to the adoption of more
credible monetary regimes, such as inflation targeting. The Taylor (2000) model conjectures that
with low inflation and lower persistence of inflation, the pricing power of firms is reduced,
curtailing their ability to pass-through costs, including those arising from exchange rate changes.
Taylor employs sticky pricing in a New Keynesian model, and gives classic emphasis to the role
of expectations, where a policy shift has lowered expected inflation. The model applies this well-
known general point to the particular case of the exchange rate part of inflationary shocks. The
Taylor hypothesis has achieved prominence from the attention it has received by empirical
testers.
Taylor uses a simple staggered pricing model to make this prediction. The firms production
depends on its price and the average price of goods produced by other firms. There are random shifts
to demand, and account is taken of a firms market power. The firm is assumed to set its price for the
next four periods and reviews its price every four periods. The firm then maximises its expected profit
given the firms marginal cost of producing goods and the expected prices of other firms. The optimal
price can then be solved for.
Exchange Rate Pass-Through in Developing and Emerging Markets 107

Three implications follow. First, the degree of price change depends on how permanent exchange
rate changes are. Changes in exchange rates affect marginal cost, but if these changes are perceived to
be temporary they will have little effect on pass-through (Froot & Klemperer, 1989). Second, if prices
set by other firms are expected to remain relatively stable, the firm has limited ability to pass on higher
costs due to exchange rate depreciation and/or a rise in import prices. Taylor argues that measured
pricing power is heavily dependent on expectations. Third, with greater international competition, it is
difficult for a firm to change its product price in response to demand shocks. Again, the degree of price
response to a demand shift depends on the permanence of that shift.
Taylor suggests that maintaining low and stable inflation has induced low ERPT, which in turn
has sustained low inflation, and is compatible with the adoption of the more credible monetary
policy regimes that have helped stabilise inflationary expectations (that is, lowering producers
forecasted cost changes). Thus, according to Taylor, the ERPT is endogenous to the monetary
policy.17 There has been extensive testing of the hypothesis by linking ERPT estimates for import
and consumer prices with proxies for monetary policy (average inflation and the variability of
inflation, and average exchange rate depreciation and the variability of exchange rate changes),
and matching the instability of ERPT measures to the timing of shifts in monetary policy regimes
(see Section 6). The Taylor hypothesis also has implications for the exchange rate reaction
function in multi-equation systems that endogenise the exchange rate. A greater emphasis on
inflation in the monetary policy rule should increase the negative feedback onto the exchange rate
from recent exchange rate changes or recent inflation.

3. The Theoretical Underpinnings of Empirical Pass-Through Analyses


We illustrate the partial equilibrium micro-founded mark-up equation that is the basis for the empirical
analysis of ERPT to import prices using both single equations and some systems methods (which
introduce some general equilibrium features, for example, the Johansen method, see below), at both
aggregate and disaggregated price levels. We extend the exposition of Campa and Goldberg (2005) for
ERPT to import prices, to include a role for the domestic costs of the importing country and an
expanded definition of the exporter countrys costs with commodity prices.
The import price index PM of a country measured at the point of entry can be defined as the price
index of the exporter to that country, PX , converted to domestic currency using the exchange rate E
(expressed in foreign currency per unit of domestic currency of the destination country, so that a rise in
the exchange rate is an appreciation):

PM PX =E (1)

Expressing the prices in logs, denoted by lower case letters, gives:

p M pX  e (2)

The exporters prices are expressed as a mark-up (MKU PX ) over the exporters marginal costs
(MCOST X ):

PX MKU PX MCOST X (3)

Using lowercase letters to reflect logarithms, and substituting Equation (3) into Equation (2), yields:

pM mkupX mcost X  e (4)

As noted in the Introduction, the mark-up, which is inversely related to the price elasticity of demand
in the destination market, depends on the shape of the demand curve. The mark-up is unlikely to be a
108 J. Aron et al.

constant18 when the price and quantity vary, and it will also vary by sector or firm with the degree of
product differentiation and market structure.19 The mark-up is a function of the real exchange rate and
potentially of other macro-variables. Campa and Goldberg (2005) formulate the mark-up in terms of
the nominal exchange rate, but the real exchange rate is more relevant: it is more difficult to get a large
mark-up if domestic prices in the destination market are low relative to the foreign prices expressed in
domestic currency. The relationship between the mark-up and the (time-varying) real exchange rate,
defined as the nominal rate adjusted by the price ratio of unit labour costs in the exporting country
(wX ) and destination country (wM ), and expressed in logs, can be simply approximated by:

mkupX e  wX wM (5)

The value of lies between 0 and 1: at = 0 there is PCP; and at = 1 there would be complete LCP
(that is, the mark-up varies one-for-one with the exchange rate, if marginal costs were constant). In
between, there is a degree of LCP, lending support to the theoretical emphasis on this type of pricing,
even before distribution costs are added. The constant is given by .20 For simplicity, Equation (5)
omits other influences, such as demand conditions in the importing country. The exporters marginal
costs are postulated to rise with a weighted average of market wages in the exporting country, wX , and
commodity prices such as oil prices, pcomX , and with demand conditions21 in the exporting country,
yX , and in its destination market, yM . Expressed in logs:

mcost X 1 wX 1  1 pcomX 3 yX 4 yM (6)

Combining the above equations, import prices at the point of entry, before local taxes and distribution
costs are added, can be specified as:

pM  1  e wM 1  wX 1  1 pcomX 3 yX 4 yM (7)

Equation (7) generalises the formulation of Campa and Goldberg by introducing the importing
countrys relative domestic costs into the mark-up function, and exogenous commodity prices into
the exporters marginal cost function. Note that this describes a long-run relationship and is not about
temporary price stickiness.
The (long-run) ERPT coefficient is 1  , capturing the exchange rate elasticity of import
prices. If 0, so that 1, then there is producer currency pricing (PCP). The import price
changes one-for-one with the exchange rate; that is, there is full ERPT. In this case, the mark-up is a
constant, for with 0, it does not depend on the exchange rate (Equation 5). At the other extreme, if
1, so that 0, then there is no ERPT to prices. This is (complete) local currency pricing (LCP),
where the exporters fully absorb any exchange rate fluctuations by squeezing their mark-ups, giving
importers a stable price.
Equation (7) can be expressed as a long-run log linear regression specification, and this is
conventionally used in the empirical literature to estimate ERPT to import prices (using several
different methodologies, discussed further below):

t et 1 wt 2 pcomt 3 wt 4 yt 5 yt "t
pM X X M X M
(8)

where pM is the local currency import price, is a constant, e is the (nominal) exchange rate,22 wX and
wM are control variables representing exporter costs and domestic costs, pcomX captures a further
element of exporters costs stemming specifically from commodity prices, such as oil prices, and yM
and yX control for demand in the destination market and exporters market.
There are several plausible theoretical restrictions on Equation (8). Long-run lack of money illusion,
when the exchange rate does not change, requires the price homogeneity restriction 1 2 3 1.
This ensures that doubling foreign costs and destination country domestic costs, for instance,
Table 1. Typology of multi-country studies for selected emerging market countries investigating ERPT

Sample and structural Single equation or Is long-run price Which ERPT results
Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

Consumer price aggregate (CPI)


Razafimahefa (2012) Sample: 1985Q1 SSA as a whole SYSTEM for panel No destination cost No domestic or foreign 1-, 4- and 8-quarter
Panel and time series 2008Q2. (panel); and Differenced VAR controls. No exporter prices are included: ERPT for individual
Quarterly CPI (IFS) Breakpoint: Chosen for individual countries models, 1 or 2 lags: cost controls. No long-run homogeneity countries from
and NEER (BIS) the largest fall in ERPT (unspecified a. bivariate with only demand controls. is violated (in specif. accumulated
coefficient as 1997 countries dropped the exchange rate SSA panel: examine b., only CPI and NEER normalised impulse
(apparently all four due to lack of data). and the CPI (time also directional are assumed to responses.
quarters). The ERPT series and balanced asymmetry with cointegrate). For the SSA panel,
results are also panel); depreciation dummy long-run ERPT (see
averaged and analysed b. above, plus levels and fall in ERPT with online Appendix 1 for
by fixed/flexible term with CPI and post-1997 dummy criticism).
regime groups. NEER (details (interacting with log Correlations given
unclear). NEER). between unspecified
(Balanced panel only, ERPT elasticities and
fixed effects, OLS). macro/micro drivers.

SYSTEM for individual


countries
Lag lengths not reported
(Schwartz criterion).
Kohlscheen (2010) Sample: from inception Brazil, SYSTEM No destination cost No long-run terms. 3-, 6-, 9-, 12-month
Time series of the floating S. Korea, Differenced VAR controls. No exporter ERPT for individual
Monthly CPI (IFS) and exchange rate regime Mexico, models, 12 lags: cost controls. countries from
NEER (BIS) as defined by Reinhart Indonesia, a. bivariate with only Destination demand accumulated impulse
and Rogoff (2004), S. Africa, the exchange rate proxied by the log of responses.
until October 2008. Thailand, and the CPI; the industrial Simple correlations
Breakpoint: No Czech Republic, b. above, plus the production index. between 6- and 12-
breakpoint. Exchange Philippines. (differenced) log of month ERPT
rate regimes are output. Tests elasticities and macro/
isolated as above. robustness to micro drivers.
ordering.

(continued )
Exchange Rate Pass-Through in Developing and Emerging Markets 109
110 J. Aron et al.

Table 1. (Continued)

Sample and structural Single equation or Is long-run price Which ERPT results
Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

Akofio-Sowah (2009) Sample: 19802005 15 sub-Saharan SINGLE EQUATION No destination cost No long-run terms. Reports the regressions
Panel maximum; samples are African and 12 Differenced equation: controls. Exporter costs for SSA and LA. Does
Quarterly CPI (IFS) unclear but short; Latin American a. current log proxied by trade- not give the net ERPT
and NEER (IFS) SSA region: 332 countries (online (NEER); one lag in weighted CPI. after one quarter by
observations or 5 years Appendix 2); the dependent adjusting for the
data per country on grouped as variable; currency The currency group interactive terms
average; LA region: SSA/LA. (Removed group dummies and dummies, real output (footnote 2). But no
189 observations or 4 4 hyper-inflation current control growth, change in trade interactive terms are
years data per country countries). variables (see RHS). openness, change in significant except
on average. (Unbalanced panel exchange rate volatility change in volatility for
Breakpoint: No with fixed effects, each interacted with SSA, and currency
breakpoint. Exchange separately estimated for current log (NEER). groups for both SSA
rate regime groups LA and SSA regions). (Last 3 not included/ and LA.
identified by dummies: tested separately).
4 currency unions Coefficients on
(Africa); 3 dollarisation currency groups show
groups (LA). the relative ERPT of
groups.

(continued )
Table 1. (Continued)

Sample and structural Single equation or Is long-run price Which ERPT results
Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

Mihaljek and Klau Sample: 1994Q1 to 14 emerging market SINGLE EQUATION No destination cost REER gap is included: 4 quarter ERPT (short
(2001, 2008) 2006Q2 (2008 paper) countries (online Differenced equations: controls. Exporter costs the REER minus a run) for individual
Time series and (max. sample) Appendix 2). a. current log (NEER) proxied by trade- long-run trend countries in Graph 5,
Quarterly CPI (IFS) 19812001 (2001 and up to 3 lags; up weighted CPI. (calculated using the with and without
and NEER (IFS) paper). to 3 lags on Destination demand HP filter). This controlling for long-run
Breakpoint: ERPT dependent variable; proxied by output gap. imposes homogeneity with REER gap (from
coefficients are and current and up to Regressions run with (PPP); and the trends their Tables A2 and
compared for the above 3 lags on the control and without the REER potentially capture A3). The ERPT
two overlapping variables. gap: effectively evolving productivity estimates are incorrect
samples. However, b. the above, plus introduces a weighted differentials amongst as they fail to correct
specifications differ for current and up to 2 foreign CPI term in the countries. for REER gap and
the 2 papers; moreover lags of REER gap. long-run. lagged dependent
in 8/14 countries the (from 2008 paper). variable (see
samples only begin in Size and directional footnote 2).
the mid-90s (for asymmetry tested with The stability of ERPT
example, Turkish simple dummies (that result is unreliable (see
sample begins in is, not interacted with column 2 at left).
1995Q2 in earlier log (NEER)).
paper).
Choudhri and Hakura Sample: 19792000. 71 countries SINGLE EQUATION No destination cost No long-run terms. Did 0-, 1-, 4- and 20-
(2006) Breakpoint: Samples including Differenced equation: controls. Exporter costs not find evidence for a quarter ERPT for all
Time series are divided by inflation developing a. current & log proxied by trade- stationary REER using countries with single or
Quarterly CPI (IFS) regimes (their Table 3) countries. (NEER) and lags; weighted CPI. No country and panel tests. dual inflation regimes
and NEER (IFS) and regressions are run several lags in the demand controls. (the lagged dependent
separately for each. dependent variable; variables are dealt with
and several lags in as in footnote 2).
the control variable Cross-section
(see RHS) beginning regressions of 0- and
at (t1). Lag order 20-quarter ERPT
determined by elasticities on macro
Schwartz criterion drivers and openness.
not reported.

(continued )
Exchange Rate Pass-Through in Developing and Emerging Markets 111
Table 1. (Continued)
112 J. Aron et al.

Sample and structural Single equation or Is long-run price Which ERPT results
Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

Goldfajn and Werlang Sample: the maximum 71 countries (their SINGLE EQUATION No destination cost REER gap is included: 1-, 3-, 6-, 9-, 12-, (18-)
(2000) period: 19801998 Table A1) in Differenced equation: controls. No explicit the REER minus a month ERPT for all
Panel (unclear if it is a groups: by region; a. one lag in dependent exporter controls, long-run trend countries, for regions
Monthly CPI (IFS) and balanced panel). developed, variable at (t1); though the REER gap (calculated using the and for groups, with
NEER (IFS) Breakpoint: developing (28) and lagged control is included: effectively HP filter). This and without the
No breakpoints. emerging (24); variables (see RHS) introduces a weighted imposes homogeneity interaction terms.
Countries are grouped more or less all at time (t1); the foreign CPI in the long (PPP) and the trends
by indebtedness. indebted; OECD dependent variable run. Demand controlled potentially capture
Interaction terms with and non-OECD. (inflation rate) and for by real GDP (or evolving productivity
trade openness are regressor exchange industrial prod index) differentials amongst
included. rate depreciation are gap. Controls include countries.
both accumulated for openness and
j periods ahead: sometimes survey
inflation [t, t + j], expectations of
and log (NEER) exchange rates.
[t1, t + j1]; that is,
the latter first The GDP gap, inflation,
included openness and REER
at (t1). gap are each interacted
(There are overlapping with log (NEER)
data.) [t1, t + j1].
(Panel with fixed
effects, GLS.)
(continued )
Table 1. (Continued)

Sample and structural Single equation or Is long-run price Which ERPT results
Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

Consumer price aggregate (CPI) and import prices disaggregated to products (both at the dock and retail)
Frankel, Parsley and Sample: 19902002. One group of 76 SINGLE EQUATION No destination cost Long-run PPP is Base model a. gives
Wei (2012) Breakpoint: No specific countries; and sub- Differenced equation: controls in base model. imposed in ecm term; ERPT after one year for
Panel breakpoint. Interact grouped: a. base model: current Exporter costs: that is, homogeneity all countries, and
Annual IUV of 8 each of the ecm term developing/high log (NEER); no matching prices from for foreign prices is developing/high
commodities retail and log (NEER) with income. lags in dependent exporting countries for satisfied. income sub-groups.
imports (EIU, footnote a trend, for the sample variable; current 8 import goods in Net ERPT not
4); matching products as a whole. exporter cost (see import equations; in calculated for models
IUV at the dock RHS) and ecm CPI eqn, uses trade- b. (see footnote 2)
imports (UN); (at t1); weighted foreign CPI. For 3 dependent
aggregate CPI (WEO); b. the above, plus variables CPI, at the
and bilateral nominal interaction terms Interaction terms in dock and retail
exchange rates (EIU). for each of the ecm models b with: linear specific import product
term and log trend, log measures of: prices: in the models b.
(NEER): with income, tariff, distance, the interaction terms
macro/micro drivers size, destination real are added sequentially
and a trend (see wage, average (that is, specific-to-
RHS). inflation; and exchange general). Variables in
(Pools the 8 goods, 12 rate volatility. (The the interaction terms
years and 76 countries uninteracted variables were not de-meaned
with product and/or were not tested (see footnote 2).
country dummies) separately in
regression.)

(continued )
Exchange Rate Pass-Through in Developing and Emerging Markets 113
Table 1. (Continued)
114 J. Aron et al.

Sample and structural Single equation or Is long-run price Which ERPT results
Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

Import price aggregate


Brun-Aguerre, Fuertes, Sample: for time series 18 emerging SINGLE EQUATION No destination cost Freely-estimated ecm For each of the models
and Phylaktis and unbalanced panel markets and 19 Three differenced controls. Exporter costs at (t1) in models a. a., b. and c., 1-quarter
(2012)** the maximum sample is developed markets specifications: use a contentious proxy and c.: a linear (short-run) ERPT for
Panel and time series 1980Q12009Q3; (Online Appendix a. current log see Section 5: the combination of levels individual countries,
Quarterly IUV and balanced panel sample 2). (NEER); one lag in import-weighted total of IUV, foreign price and averaged for all,
NEER (see their WP is 1997Q12009Q3; dependent variable; export unit value and exchange rate. over (i) full sample
version) for drivers of ERPT, current exporter cost indices of trading Long-run homogeneity (unbalanced panel),
sample is 2004Q3 (see RHS) and ecm partners. No demand for foreign prices is not and (ii) balanced panel
2009Q3. (at t-1); controls. imposed. sample.
Breakpoint: No b. above, plus 4 lags on Long-run
breakpoint. log (NEER) and Panel analysis of ERPT (equilibrium) ERPT
on exporter cost but drivers examines: from ecm for models a.
no lagged dependent foreign exchange and c. For model b.,
variable or ecm; volatility; asymmetry five-quarter ERPT is
c. as in b. but with ecmof ERPT; import reported.
(at t1). dependence; tariffs;
(Equations estimated inflation; relative
Panel (fixed effect)
for each country, OLS.) wealth; global PMI regressions of short
index; output gap.
term ERPT elasticities
on macro/micro
drivers.
(continued )
Table 1. (Continued)

Sample and structural Single equation or Is long-run price Which ERPT results
Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

Barhoumi (2006) Sample: 19802003. 24 developing SINGLE EQUATION Destination cost In their Tables 5 and Long-run (equilibrium)
Time series Breakpoint: No countries Level specifications: controls (and 6, long-run ERPT for 24 countries
(also run panel breakpoint, but (online Appendix a. level of current competing price) homogeneity is not from FMOLS and
regressions to test for countries are also sub- 2). log (NEER) and proxied by PPI. imposed and not DOLS methods.
homogeneous long- grouped by inflation current controls (see Exporter costs proxied satisfied for individual Averages the above
run response across regime, trade regime RHS) (no lagged by trade-weighted countries equations. ERPT measures for
countries) and exchange rate dependent variable). CPI (they wrongly groups by inflation,
Annual IUV and NEER regimes (their Table 9). b. a. plus differenced use domestic PPI exchange rate and trade
(IFS) leads and lags in all instead of domestic regimes.
RHS variables (no CPI, although the IFS
lagged dependent measures of REER and Test for and report no
variable). Lag NEER use the CPI homogeneity of long-
lengths not reported. definition see Section run ERPT for countries
5). Demand controlled in panel regressions.
(Equations estimated
for each country, for by GDP.
FMOLS and DOLS
methods.)

(continued )
Exchange Rate Pass-Through in Developing and Emerging Markets 115
Table 1. (Continued)

Sample and structural Single equation or Is long-run price Which ERPT results
116 J. Aron et al.

Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

Import price aggregate and export price aggregate


Bussire and Peltonen Sample: 1980Q1 41 countries: 9 SINGLE EQUATION Destination cost No long-run terms. Did For IUV and EUV
(2008) 2006Q2 maximum: Asian; 5 L. Differenced equations controls proxied by the not find evidence using models, 1-quarter
Panel and time series some time series are American; 7 Central for IUV and EUV take PPI. Exporter costs EngleGranger (short-run) ERPT for
Quarterly PPI, IUV and short; for example, and E. European; 7 the same form: proxied by trade- method. individual countries,
EUV (IFS, Global China (36 Middle Eastern and a. current change in the weighted CPI and oil and averaged for all,
Insight). No separate observations). African; and 13 foreign trade- price and non-oil over full sample
exchange rate variable Breakpoint: Stability of advanced weighted price (no energy price (all in (unbalanced panel); but
embodied in foreign ERPT examined with economies separate exchange foreign currency foreign price variables
price variable, see (30-quarter) rolling (online Appendix 2) rate term); current terms). No demand giving ERPT
column 5. regressions and and grouped change in the PPI; controls. Dummy elasticities are often
breakpoint tests. (panel): emerging/ one lag in the variables for crises and insignificant in
advanced. dependent variable; hyperinflation. regressions.
plus current controls
Note restriction: Long-run ERPT is
(see RHS). foreign prices and the quoted (defined as
(Equations estimated exchange rate have the ERPT elasticities
for each country, OLS, same coefficient the divided by (1-
and pooled) short-run ERPT; this is coefficient on lagged
not formally tested dependent variable),
(only by simple that is, long-run
correlations). captured by only one
quarter.
Bivariate cross-country
regressions of short-run
ERPT elasticities on
macro/micro drivers.
(continued )
Table 1. (Continued)

Sample and structural Single equation or Is long-run price Which ERPT results
Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

Import price aggregate (but also CPI and PPI)


Coulibaly and Kempf Sample: 1989Q1- 27 emerging SYSTEM No destination cost No long-run terms. Impulse response
(2010) 2009Q1, but countries analysed Differenced VAR controls in a. but function pictures given
Panel short samples in some in groups: 15 models, 3 lags: controlled by PPI in b. for ERPT to import
Quarterly CPI (IFS), cases; for example, inflation targeters a. (oil price, output gap, Exporter costs are oil prices, PPI and CPI
PPI (IFS), IUV start-date for IT and 12 non-targeters money, NER and price in a. and oil price before and after the
(IFS 5 countries have samples: Hungary (online Appendix CPI); plus import price in b. adoption of targeting.
price indices) and (2001:Q2), Indonesia 2). b. 7 variables: (oil Demand controlled for Forecast variance
bilateral nominal rate (2005:Q3), South price, output gap, by the output gap. analysis of the
against US (IFS, Africa (2001:Q1), money, NER, import Compare impulse contribution of
mainly). Thailand (2000:Q2), price, producer price, response functions in exchange rate shocks to
Turkey (2006:Q1). CPI). country subsamples, inflation before and
Breakpoint: two (Panel estimation, based on date of after adoption of
samples with break at GMM, transforming adoption of inflation targeting.
date of adoption of variables as deviations targeting.
inflation targeting from forward means to
regime for different remove fixed effects.)
countries.

(continued )
Exchange Rate Pass-Through in Developing and Emerging Markets 117
118 J. Aron et al.

Table 1. (Continued)

Sample and structural Single equation or Is long-run price Which ERPT results
Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

Ito and Sato (2008) Sample: Post-crisis 5 East Asian SYSTEM No destination cost No long-run terms. 1-, 6-, 12-, 18- and 24-
Time series samples: 1997/8-2006 countries: Differenced VAR, at controls in a., b. or c. month ERPT for
Monthly import prices (their Table 1). Indonesia, Korea, most 3 lags for d.: but controlled by PPI individual countries
(mix of prices and Breakpoint: No Thailand, the a. (oil price, output gap, in d. Exporter costs are with accumulated
IUV, IFS mainly, breakpoint, but analysis Philippines, and money, NEER and oil price in a. to d. plus impulse responses to
excluding Malaysia), of the post-crisis period Malaysia. CPI); import price in d. import prices and to
PPI, CPI and NEER for Asian countries. b. (oil price, output Demand controlled for PPI and to CPI.
(IFS). gap, money, NEER by the output gap. Also Post-crisis monetary
and PPI); control for base money policy analysed.
c. (oil price, output gap, or a short-term interest
money, NEER and rate.
import price); (Prices, exchange rate
d. (oil price, output and money in logs).
gap, money, NEER,
import price, PPI
and CPI).
Tests robustness to
ordering.

(continued )
Table 1. (Continued)

Sample and structural Single equation or Is long-run price Which ERPT results
Study break-points Country coverage System Controls in equations homogeneity satisfied? are reported?

CaZorzi et al. (2007) Sample: 1975Q1 to 12 emerging SYSTEM No destination cost No long-run terms. Did 4- and 8-quarter ERPT
Time series 2004Q1 maximum: see markets in Asia, Differenced VAR controls. Exporter cost not find evidence using for individual countries
Quarterly import prices samples in their Table Central and E. models, up to 4 lags: controls are oil price Johansen with accumulated
(mix: IUV, import 1, latest start-date is Europe, a. 6 variables: (oil plus destination co-integration tests. impulse responses to
deflator, prices, IFS), 1993 (Czech)). Turkey, and Latin price, output, NEER, country import price. import prices and to
CPI (IFS) and Breakpoint: No America import price, CPI Demand controlled for CPI.
NEER (IFS, BIS, breakpoint. (online and interest rate), by GDP (or industrial Spearman/Pearson
OECD, JPMorgan). Appendix 2). with interest rate in production index). correlations: ERPT to
levels or differences Control also for short- consumer prices with
depending on unit term interest rate. inflation, depreciation,
root tests. Tests (Prices and exchange volatility and openness.
robustness to rate in logs).
ordering.

Notes: Abbreviations: IUV and EUV: import and export unit values; WEO: World Economic Outlook; ecm: equilibrium correction model; ERPT: exchange rate pass-
through; PPP: purchasing power parity; REER and NEER: real and nominal effective exchange rates; CPI and PPI: consumer and producer price indices; log (NEER):
change in the log of the NEER or proportional change in NEER; RHS: right-hand-side; IT: inflation targeting; PMI: purchasing managers index, reflecting economic
conditions; HP filter: Hodrick Prescott filter, technique for taking a long-term trend over a sample; IFS: International Financial Statistics (IMF); unbalanced panel: panel with
different sample sizes for different included countries; GLS: generalised least squares; OLS: ordinary least squares; GMM: generalised method of moments; FMOLS: fully
modified ordinary least squares and DOLS: dynamic ordinary least squares.
1. See online Appendix 2 for constituent countries in advanced, emerging and developing categories.
2. Where lagged dependent variables, ecm terms and interactive terms are included, considerable caution needs to be taken in calculating ERPT elasticities. If there are
lagged dependent variable/s concurrent with or leading the accumulated depreciation, then extraction of the ERPT measure is no longer straightforward and an algorithm is
required to extract the effects of these in the ERPT calculation (see online Appendix 1 and Choudhri and Hakura [2006, footnote 24]). If an ecm term is concurrent with or
leading the accumulated depreciation, this has to be accounted for too in the ERPT calculation. Finally, if there are interaction terms, then the net effect of ERPT has to be
calculated taking account of these terms, and the interacted variables need to be de-meaned so the original ERPT coefficient on et is still meaningful and not affected by the
different units of the interacting variables.
3. Single equation (exchange rate assumed exogenous) or System (exchange rate is endogenous).
4. The eight specialised items are alcohol (various), cigarettes, Coca-Cola, Time magazine, and Kodak film (Economist Intelligence Unit).
5. **See sections 6.2 and 6.4 for discussion of data and execution errors.
Exchange Rate Pass-Through in Developing and Emerging Markets 119
120 J. Aron et al.

eventually doubles import prices. When the exchange rate can vary, long-run homogeneity in Equation
(8) requires that foreign costs be translated at the exchange rate and hence that 1 2 . Then
doubling the exchange rate at given foreign prices, for instance, is equivalent to doubling foreign
prices at a given exchange rate. Combining these two restrictions gives the long-run ERPT as
1  3 . In the short run, such homogeneity restrictions might not hold; but in the long run
they should hold. Analogous to the discussion below Equation (7), at the one extreme, if there is zero
ERPT to prices (with complete LCP) then in the long run, 0. At the other extreme, with complete
ERPT to prices under PCP, then in the long run, 1 and 3 0.
Simpler versions of Equation (8) are generally used in the literature, omitting controls for domestic
costs and commodity prices, and sometimes also omitting demand controls. Excluding control vari-
ables that are correlated with exchange rates could result in biased estimates of the ERPT coefficient,
. Omitting domestic costs is potentially serious. Even at the dock, from the mark-up in Equation (5),
domestic costs matter since they enter the real exchange rate. And further down the price distribution
chain, the empirical literature suggests local distribution costs are important for incomplete ERPT
(Section 7). Yet some authors impose PCP pricing in the long run (that is, they assume purchasing
power parity (PPP) holds in the aggregate, see Table 1), without testing the restriction that unit labour
costs are not part of the long-run relationship above; that is, they assume 3 0. This could neglect an
important part of the transmission mechanism to prices from exchange rates. This issue is also
important in differentiating the results from single equation and systems methodologies, discussed
in Section 4.
Equation (8) captures Stage 1 ERPT. The Stage 2 ERPT, of import prices to consumer prices, can be
thought of a weighted combination of import price ERPT to producer prices, and producer price ERPT
to consumer prices. Substituting the determinants of import prices into an equation for producer prices,
and then substituting the determinants of producer prices into an equation for consumer prices, would
allow the elimination of both import prices and producer prices. The resulting reduced-form equation
for Overall ERPT of exchange rates to consumer prices resembles Equation (8), though the coefficients
will be different.
Specifically, for import prices measured further down the distribution chain as inputs into the
production of goods or retailed directly to the consumer and for domestic wholesale and retail prices,
local currency cost content would have to be added in Equation (4). For example, where D represents
such prices down the distribution chain, the foreign and domestic costs enter as a weighted average,
where is the weight on foreign marginal costs:

pD mkupD mcost X  e 1  mcost D (9)

and mcost D is a function of destination country demand, yD , and domestic unit labour, wD , and other
costs. As a result, the new Equation (8) for such prices down the distribution chain would have an
increased 3 coefficient (because of the increased weight on domestic costs) and a reduced
coefficient (because of the lower weight on foreign costs).
Finally, most papers assume log linearity of price adjustment and do not test it against alternatives.
One rationale behind non-linearities is transactions costs. These encompass not only linear propor-
tional transactions costs, like shipping costs, but also fixed costs, like menu costs. Non-linearity is
introduced because price adjustment may only begin once a particular threshold is reached; for
example, for a threshold based on the size of exchange rate shocks, small shocks are absorbed into
profit margins and ERPT occurs only for shocks exceeding the threshold. The role of transactions costs
is closely linked to the concerns of the NOE models described in Section 2. The originators of these
models call for a richer framework in theory and empirics, with proper articulation of costs (fixed and
proportional), imperfect competition and wageprice rigidities, and a distinction between retail and
wholesale pricing (for example, Obstfeld, 2002). A different type of non-linearity is presented by
structural breaks caused by regime changes. The ERPT parameter, , in Equation (8), might then not
Exchange Rate Pass-Through in Developing and Emerging Markets 121

be constant but vary over the sample. Examples include a break in the monetary policy regime. The
next section explains how non-linearities are tested for in log linear single equation models.

4. How is Pass-Through Estimated in Practice and Why Does it Matter?


This section contrasts the heterogeneous methodologies used to extract ERPT measures in the
empirical literature. The resulting ERPT measures are not directly comparable due to differences in
the underlying assumptions (though they often are compared, regardless). If, for any method, the
models are misspecified, for example by omitting relevant determinants, the results will be biased. The
time frames often differ for reported measures; they may encompass multiple trade, exchange rate or
monetary policy regimes where the ERPT is not stable. The discerning policy-maker needs to know
which method was used, how it was applied, whether the measure pertains to the long run or short run,
and whether ERPT changed over the sample, inter alia.

4.1. Single Equation Methods where the Exchange Rate is Assumed Exogenous
The statistical time series properties of the underlying price and exchange rate series affect the validity
of the different methodologies. A stylised fact for most floating exchange rates is that they are not only
non-stationary, but are difficult to distinguish from a random walk over the sample.23 Prices, too, are
typically non-stationary. In some early studies of ERPT, statistical inference was invalid, as linear
regressions using non-stationary series can produce spurious correlations (Granger, 1981).
If Equation (8) is estimated as a single equation using non-stationary data to capture the long-run
equilibrium ERPT, , this relationship is valid only if the variables can be shown statistically to form a
co-integrated relationship. This means that even though the series are individually non-stationary, a
linear combination of them, with weights captured by the regression coefficients, is stationary (I(0)). If
the series in Equation (8) are co-integrated, they can be thought of as having one or more equilibrium
or long-run economic relationships.
The majority of studies have addressed the non-stationarity issue by differencing the data to form stationary
series.24 Then a first-differenced version of Equation (8) can be estimated with several lags on the different
variables to allow a gradual adjustment to the exchange rate. Using differenced equations means the investigator
does not wish to assume the existence of long-run relationships (or that they are absent when tested).
The seminal example of the differenced single equation approach is the multi-country import price
study by Campa and Goldberg (2005), who report that co-integration was not found when tested for.
Their specification for a quarterly model, and expressed here in aggregate price index terms,25 is:
X4 X4
pM
t a eti
0 i 0
bi wXti cyM
t t (10)

where is a constant, yM
t is the real GDP of the destination (importing) country and the foreign costs
26
P4 labour costs. The short-run
are measured as a trade-weighted average of foreign unit ERPT (after one
period) is given by a0, and they define  0 ai as long-run ERPT.27 With quarterly data,
this measure would give ERPT after five quarters, since it reflects the cumulative effect of five
quarterly shocks.28 This type of model is widely applied in the literature.
Such single equation methods are based on reduced-form regressions from a partial equilibrium
model; they assume that exchange rates are exogenous, which implies that changes in the log of the
exchange rate, et , are exogenous shocks. They differ from the systems methods, discussed below,
which allow feedback effects fromPendogenous exchange rates. If the other variables in Equation (10)
were also exogenous, then  n1 i0 ai would be a discrete approximation of the impulse response
function (that characterises the time path of the dependent variable in an equation in response to a
shock from an explanatory variable) cumulated up to n periods after an exchange rate shock (see
online Appendix 1 for discussion).
122 J. Aron et al.

However, floating exchange rates and prices are determined simultaneously in a general equilibrium
setting. Neglecting the channels through which the exchange rate is influenced by other economic
variables may lead to biased and inconsistent estimates. For instance, if policy-makers raise the interest
rate in anticipation of future inflation following exchange rate depreciation, this counters the original
depreciation by appreciating the currency and the net shock is smaller. The assumption of exogenous
exchange rates produces ERPT measures for a gross exchange rate shock, without correcting for such
negative feedback from monetary policy.
Single equation models expressed in differences omit possible long-run relationships. If co-integra-
tion between long-run level variables is indeed present, this is a misspecification and will bias the
ERPT. Failure to find co-integration is attributed by de Bandt, Banerjee, and Kozluk (2008) to taking
insufficient account of structural change (assuming there has been no omission of relevant non-
stationary variables). In the usual tests for co-integration, the weights in the co-integrating vector
are assumed constant in the sample. If the long-run economic relationship (and hence the weights)
between the variables alters through, for example, technological progress, regime change or institu-
tional change, this might mistakenly find against co-integration.
It is desirable to combine the long-run co-integrating relationship between prices and their determi-
nants in Equation (8) with short-run dynamic adjustment to deviations from equilibrium induced by
shocks of various types. This can be accomplished in a single equation equilibrium correction model
(ecm), a typical formulation of which is as follows:

X
n

t c ecmt1
pM i eti i pM
ti1 1i wti
X

i0 (11)
2i pcomXti 3i wM
ti 4i yXti 5i yM
ti  t

   
where the ecmt1 1 wXt1  et1 2 pcomXt1  et1 3 wM t1  pt1  is the long-run cointe-
M

grating term with the foreign prices converted to the destination countrys currency. The speed of
adjustment to equilibrium is given by in Equation (11).29
A few studies (see Table 1) introduce a simple version of the ecm term which is the log of the real
exchange rate: (e  wX wM t1 . Generally wX is proxied by the trade-weighted average of foreign
prices (usually the CPI, and then wM is proxied by the destination countrys CPI) and e is the trade-
weighted exchange rate. This formulation effectively imposes long-run homogeneity, by assuming
without testing that 2 0 and 3 0; see Section 3. Long-run structural change, such as from
productivity change (the BalassaSamuelson effect), is addressed by creating the real exchange rate
gap, subtracting a long-run trend from the real exchange rate. Use of the Hodrick Prescott filter
technique to create this time-varying trend can strongly bias upwards the coefficient on the real
exchange rate gap.30
This equation includes the lagged import price in both the co-integrating term, ecmt1 ; and also in
(one or more) lagged changes. This can make the calculation of the time-profile of ERPT complex31
and perhaps accounts for the rarity of the ecm approach in practice. An approximation by Aron,
Farrell, Muellbauer, and Sinclair (2014) is to include an ecm term and the lagged dependent variable
only at lags pre-dating the period over which ERPT is calculated. The advantage is that ERPT
estimates can be straightforwardly calculated from a summation of the i coefficients, and the bias
from neglecting long-run information and lagged import price changes is reduced (though not
eliminated) by including older information. This equation can be estimated using ordinary least
squares.
A distinct advantage of the single equation methods is that asymmetries and other non-linearities, of
growing importance in explaining incomplete ERPT, can be straightforwardly tested using split trends
and interaction effects, or with explicitly non-linear versions. There is scarce but growing evidence of
non-linearities at the first stage of the ERPT, to import prices, and overall, to consumer prices. The
majority of papers follow Pollard and Coughlin (2003) in testing for short- to medium-run asymme-
tries by distinguishing large from small exchange rate changes, appreciations from depreciations, or a
Exchange Rate Pass-Through in Developing and Emerging Markets 123

combination of the above. Two dummy variables could be defined to identify months or quarters in
which the absolute value of the exchange rate change exceeded a certain threshold; for example, 3 per
cent (or a grid of threshold values), for large changes, LGt , and small changes, SMt . Interacting these
dummy variables with et provides separate estimates for ERPT under large and small exchange rate
changes. In a similar manner, the effect of exchange rate volatility on ERPT could be measured by
interacting a volatility measure with et .
We have mentioned that the ERPT relationship may not be stable with regime changes. There
are various ways of testing the stability of coefficients in single equation models. Several
techniques are used. Some simply test for the presence of structural breaks 32 in the ERPT
regressions (for example, Bussire & Peltonen, 2008). A direct method analyses the effect of
independent variables on time-varying estimated ERPT elasticities as the dependent variable in
regressions (for example, Brun-Aguerre, Ana-Maria, & Phylaktis, 2012). The before-and-after
approach splits samples at a chosen breakpoint, and runs separate regressions on the shorter
samples, comparing the elasticities in each (Coulibaly & Kempf, 2010). A related approach, with
the advantage that the sample is not curtailed, introduces an interaction term into the linear
model. The coefficient of the interaction term (for example, between et and a dummy that
equals 1 during the inflation targeting era [for example] and 0 otherwise) reveals whether there
is a change in pass-through in the regime period (Akofio-Sowah, 2009; Goldfajn & Werlang,
2000). Finally, explicitly non-linear estimation methods that allow varying parameters over time,
such as the Kalman Filter model or Markov Switching models, could potentially be used.

4.2. Systems Methods with Feedback Effects


Systems models allow the endogeneity of the exchange rate and cost variables. In the absence of
structural breaks and non-linearities, the Johansen systems method (Johansen, 1988; Johansen &
Juselius, 1990), a vector autoregressive (VAR) model system in levels, could be used to test for
multiple, long-run, co-integrating relationships amongst the five potentially endogenous I(1) variables
in Equation (8). The same long-run price homogeneity restrictions (Section 3) should apply. These
restrictions would imply that: (1) foreign producer and oil prices, in the long run, enter the system
converted into destination country currency at the exchange rate; and (2) doubling domestic costs and
domestic currency foreign prices and oil prices must double import prices in the long run. For smaller
economies, a further assumption can be imposed, that foreign producer and oil prices are strictly
exogenous. The long-run solution will thus contain four domestic currency-denominated variables:
import prices; domestic (unit labour) costs; foreign prices; and oil prices. At least two co-integrating
vectors might be expected, and could be interpreted as equations for import prices and for domestic
(unit labour) costs (a third vector might capture long-run exchange rate behaviour).
The majority of published studies using the Johansen methodology report only the equilibrium
measure of ERPT while taking account of lagged short-run dynamics in adjusting to equilibrium (for
example, Karoro, Aziakpono, & Cattaneo, 2009). However, it is short- to medium-run ERPT that is of
most interest to monetary policy. Impulse response functions can be generated in the co-integrated
system and ERPT elasticities can then be estimated for any horizon. As noted above, these will differ
from single equation estimates of impulse response functions that ignore potential offsetting feedbacks.
The most frequently used systems method is the analysis of a price distribution chain in a
differenced VAR model, identified to allow causal relationships. Using differenced prices avoids
non-stationarity problems, but neglects the possible long-run relationships, and may imply biased
ERPT measures. The seminal paper is McCarthy (2007): his earlier research has promoted a large
literature for individual countries. Most VAR-based studies (for example, Faruqee, 2006; Ito & Sato,
2008; Korhonen & Wachtel, 2006), make use of the Cholesky decomposition to achieve identifica-
tion: a triangular structure is imposed on the equations of the model, with the most exogenous
dependent variables placed first in the chain (Stock & Watson, 2001). The ERPT is determined by
the (cumulative) impulse response function after applying a unitary exchange rate shock to the system.
124 J. Aron et al.

The identification method, however, assumes a particular ordering of the price variables, and the
ERPT estimates can be sensitive to the ordering, requiring robustness tests.
The differenced VAR and Johansen methods have degrees of freedom constraints, limiting the
variables and lags that can be included which potentially creates biases. Further, exchange rate changes
may reflect not only stochastic shocks, but also systematic changes in policy (for example, monetary
policy), but the related variables are usually omitted in the typical VAR. Shocks that change expecta-
tions of future monetary policy (for example, a political shock) can cause co-movements in prices and
exchange rates that are not linked to ERPT per se. An alternative approach, mostly specified in the
NOE tradition, is the dynamic stochastic general equilibrium (DSGE) model; for example, in Bouakez
and Rebei (2008) and Devereux, Engel, and Storgaard (2004). The endogeneity problems of the single
equation technique are avoided, and, as the model is structured, shocks can be unambiguously
identified, given the assumed theory and the analysis made conditional on the shocks. The number
of variables modelled is not necessarily as restricted as in VAR models, though typically the DSGE
models are linearised and limited in size (for example, there are five variables in the model of Bouakez
and Rebei [2008]). However, the assumed theory is seldom tested against more general specifications,
so that DSGE models may be imposing restrictions on the data that would be rejected if tested.

4.3. Contrasting the Methods


Policy-makers should check the findings from both systems and single equation models and be aware
of the possible biases. A significant advantage of single equation methods is that, if they are properly
specified to satisfy long-run homogeneity restrictions, they allow short-run ERPT estimates at various
horizons to be calculated simply without recourse to a full systems model. Single equation models,
whether specified in levels or differences, can more easily handle structural breaks and asymmetries.
With non-linearities proving important in the empirical literature, this is a significant advantage. Single
equation models in first differences will be more robust to shifts in the mean due to structural breaks.
But they assume no significant equilibrium relationships between prices and their determinants which
may bias the result (see online Appendix 1).
The above advantages come at the cost of assuming the exchange rate and other determinants are
exogenous and hence neglecting the feedbacks to domestic costs and to import prices via the exchange
rate. Caution thus needs to be exercised in interpreting single equation ERPT estimates as responses to
exogenous shocks.
By contrast, a systems approach allows initial exchange rate shocks to be partially reversed through
feedback effects; for example, due to the reaction of monetary policy. Not all of the initial shock is
permanent, therefore, typically reducing estimates of long-run ERPT compared to those from single
equation models which treat exchange rate changes as permanent shocks. However, in the (linear)
Johansen systems method, VARs in differences and in simple DSGE models based on linearisations of
the underlying system, structural breaks and non-linearities cannot be addressed. One needs to go
beyond these traditional approaches and handle non-linearities and breaks in larger multi-equation
models, which will then need stochastic simulation to obtain impulse response functions and the ERPT
estimates.

5. Data Pitfalls for Emerging Market Countries


For emerging market countries, the available time series data on exchange rates, prices and especially
domestic costs and demand proxy variables may be limited. This constrains the possible methodolo-
gies that can be applied; for example, co-integration techniques require long time series, even with
high frequency sampling of data. Sample size becomes critical when investigating asymmetries (for
example, in order to have a sufficient number of appreciation and depreciation episodes). Long
samples, on the other hand, may span different trade, exchange rate or monetary regimes, and the
ERPT relationship could be altered by structural breaks, so that variation over time of the ERPT
Exchange Rate Pass-Through in Developing and Emerging Markets 125

elasticities needs to be tested for. Very short time series are typical of the micro-data on prices (see
Section 7).
Even for industrialised countries, import price data may be less than adequate.33 In the absence of
comparable trade price data, there is continued wide-spread use of import (and export) unit values
(that is, value divided by quantity for each item). These price proxies suffer from well-known
deficiencies (Menon, 1995). Unit values alter with changes in the price, but also with the quantities
of items shipped (even for identical imports that are bundled in a different way). Measurement errors
can be reduced by disaggregating to homogeneous commodity classifications; but the measurement
bias remains for aggregated data. Import prices are also distorted by the prevalence of non-tariff
barriers, even where tariffs have largely been reduced and made homogeneous (see Menon, 1995, p.
227). Domestic prices such as the CPI may be poorly constructed with inadequate adjustments for the
introduction of new goods or those where prices and quality change rapidly (for example, mobile
phones and computers; see Boskin Report, US [1996]), a neglected issue in CPI construction in
emerging market countries.
Menon (1995) advocates the use of a currency-contract weighted exchange rate to give a true
representation of the currency fluctuation faced by the exporter. Most studies proxy this with (trade-
weighted) effective exchange rate indices. The choice of exchange rate index affects estimated ERPT:
Pollard and Coughlin (2006) found sharp variation across United States manufacturing industries with
eight constructed exchange rate indices (varying indices by countries and weighting arrangements). In
this survey, all but one study (Table 1) uses nominal effective exchange rate indices (with the additional
advantage of allowing some exchange rate variation in fixed bilateral regimes). Using a bilateral
exchange rate arbitrarily assigns a weight of zero to all other trading partners, introducing biases.
Proxies are needed to control for the marginal cost variables which cannot be directly measured,
and the cost indices typically used may be good proxies for average cost but not for marginal cost.34
Yet Bussire and Peltonen (2008) point to strong biases when excluding these controls. The bulk of
earlier studies (and Brun-Aguerre et al. [2012] in Table 1) unfortunately use a world price variable
constructed as trade-weighted export prices (or export unit values) as a proxy for exporters costs
(Menon, 1995). If unit value indices, these are subject to compositional changes. Perhaps more
seriously, exporters pricing decisions are already partly incorporated in these country-wide export
prices: unless there is no pricing-to-market or the same pricing-to-market to all markets, there will be
distortions (see Menon, 1996). Recent studies, with easier recourse to real effective exchange rate
data,35 typically use trade-weighted consumer prices. The drawback of these is the preponderance of
non-traded goods and services in the CPI.
Moreover, while considered the most comparable index across countries and hence often used in
published REER measures, a little discussed issue is that countries differ in whether the CPI contains
housing costs, which makes a considerable difference.36 These problems can be limited using the
trade-weighted foreign PPI: it measures costs at an earlier stage than the export price, often includes
highly traded commodities, and does not depend on the export market targeted. The trade-weighted
unit labour cost (used by Campa and Goldberg (2005)), from an even earlier stage of the production
process and excluding oil costs, is arguably less relevant than the PPI.
Sometimes commodity prices such as oil prices37 or an index of commodity prices are added to
capture other foreign costs and supply side effects, helping to disentangle these from exogenous
exchange rate effects. If the weighted PPI includes oil, this may make the oil price redundant, but this
remains an empirical question. Some VAR studies include only an oil price, ignoring domestic sources
of inflation as well as other foreign sources.
The vast majority of studies neglect the destination country cost measures (for example, unit labour
costs). Excluding domestic cost controls is especially serious in CPI equations, particularly at monthly
frequencies, as wage shocks are more likely in emerging/developing countries. Exclusion also usually
entails the violation of long-run price homogeneity (Sections 2 and 4). Sometimes the PPI is used to
proxy for domestic costs and competing prices (Coulibaly, 2010); the PPI adjusts more rapidly than
wages and is a good measure of local costs. But an important caveat is that while it works well in a
system, in a single equation the PPI is a poor proxy because it is highly endogenous. Unit labour costs,
126 J. Aron et al.

in contrast, respond with a long lag to inflation, as wage settlements are not frequently made. If unit
labour cost data are unavailable, they could be substituted by nominal manufacturing wage rates; then
productivity trends from output per worker data, or at the least, a time trend, should also be added to
the equation to correct for productivity changes.
The availability of data may be dictated by the frequency chosen for the analysis: demand measures
are typically unavailable for higher frequency data; for example, GDP data are usually published
quarterly with considerable lags, and often heavily revised. The output gap and the rate of growth of
real GDP are common demand proxies. The former suffers from the endpoints problem in its
construction (using the Hodrick Prescott filter). Another problem common to both measures is that
they pick up negative supply shocks, relevant in developing countries vulnerable to supply shocks. If
growth is negatively impacted by drought/floods (Africa, Thailand), hurricane (Caribbean) or Tsunami
(Indonesia), the shock causes inflation not disinflation and reflects a rise, not a fall, in excess demand.
Discussion of the advantages and disadvantages of aggregate versus disaggregated data is postponed
to Section 7.

6. Empirical Findings for Emerging Market Countries Using Aggregate Price Indices
Having covered the advantages and disadvantages of different methodological and data choices in
Sections 4 and 5, we now take a critical look at the reliability of empirical evidence on ERPT. Are the
findings from different methodologies on ERPT for industrial countries replicated for less advanced
countries? We cover the following aspects in Sections 6.1 to 6.7: (1) the degree and dynamics of
ERPT; (2) the diversity of estimates across a single country; (3) differences in ERPT across groups of
countries; (4) evidence for asymmetries; (5) evidence for the instability of ERPT with regime change;
(6) sensitivity to exchange rate volatility; and (7) the macro and micro drivers of ERPT.
Three tables summarise methodology and comparative findings. Table 1 is an empirical typology for
multi-country studies of ERPT to import, export and consumer price indices in developing and
emerging market countries. Table A1 in the online Appendix 2 presents the diverse findings for
South Africa, from single-country and multi-country studies. Table 2 contrasts ERPT estimates across
different country groups. The sample of countries classified as emerging needs to be clarified,
especially when comparing the findings across studies and with advanced economies (see Table 1
and online Appendix 2).

6.1. The Degree and Dynamics of ERPT


For the advanced economies, incomplete ERPT to trade and domestic consumer prices, assuming
linearity and parameter stability, is the almost uniform result for most currencies; and the lags of the
partial ERPT are often considerable. Tables 1, 2 and A1 confirm these findings for emerging and
developing countries.38
Even at equilibrium, the ERPT to trade prices is generally incomplete for emerging markets
(Barhoumi, 2006). The exception is where inflationary economies are included without controls for
destination wage costs, which biases up the role of the exchange rate sometimes to over 100 per cent.
As expected, the ERPT to consumer prices is even more incomplete than for trade prices. Lags in the
transmission of exchange rate changes to such prices tend to be at least a year before the full extent of
(incomplete) ERPT appears to be reached (for example, Choudhri & Hakura, 2006). In most studies,
however, especially with VAR studies in first differences, the lags are very short and are insufficient to
reliably ascertain the asymptote for ERPT, even when the lagged dependent variable is included.
Column 4 of Table 1 documents the lag lengths used (where reported): typically these are a year or
less, distorting the results. However, in Choudhri and Hakura (2006), a more flexible lag structure is
allowed and tested in a single equation model (Table 1). Sophisticated computations of the impulse
response function are required, and the lag response up to 20 quarters is shown.
Analogous to the advanced economies, the EPRT to trade and consumer prices is highly hetero-
geneous across individual emerging market countries. This is clear from the multi-country studies in
Table 2. Contrasting ERPT estimates for groups: emerging, developing and advanced countries

Study, sample and period Advanced countries Developing countries Emerging countries

ERPT to trade (export and import) prices


The advanced country benchmark is: 46% (after 1 quarter)#
Campa and Goldberg (2005) 64% (after 5 quarters)#
(OECD), 19752003
Choudhri and Hakura (2012) 19792010: 60% (1 quarter)# 19792010: 54% (1 quarter)#
(18 advanced; up to16 emerging, 19851997: 55% (1 quarter)# 19851997: 47% (1 quarter)#
varies in the two periods), 19792010
19982010: 49% (1 quarter)# 19982010: 72% (1 quarter)#
Brun-Aguerre et al. (2012) 58%, 56%, 60% (models a,b,c after 60%, 61%, 60% (models a,b,c after 1
(19 advanced, 18 emerging), 19802009Q3 1 quarter) quarter)
(max.)** 74%, 100%, 47% (models a,b,c 63%, 100%, 87% (models a,b,c at
at equilibrium) equilibrium)
Frankel et al. (2012) (41 high income) (DEM: for 2 low income and 15 lower-middle and 24 upper-middle income)
(76 countries), 19902002, (8 specialised 13% (after 1 year) 37% (after 1 year)
import products)
Bussire and Peltonen (2008) Export (EUV): 22% (1 quarter) Export (EUV): 34% (1 quarter)
(27 emerging), 1990Q1 to 2006Q2 Import (IUV): 35% (1 quarter) Import (IUV): 35% (1 quarter)
CaZorzi et al. (2007) (For G3: US, Japan, Euro area) (For 12 markets excl. China)
(12 emerging), 19752004Q1 (max.) 24%, 114%, 60% (4 quarters) 78% (after 4 quarters)
38%, 105%, 72% (8 quarters) 104% (after 8 quarters)
Barhoumi (2006) (For 9 emerging) (For 15 developing)
(24 developing), 19802003 88% (equilibrium) 84% (equilibrium)
(DEM: for 9 emerging and 15 developing)
83% (equilibrium)
ERPT to CPI
The advanced country benchmark is: 23% (long run)#
Gagnon and Ihrig (2004)
(20 industrial countries), 19712000
Frankel et al. (2012) (41 high income) 2% (after 1 year) (DEM: for 2 low income and 15 lower-middle and 24 upper-middle income)
(76 countries), 19902002 34% (after 1 year)
Razafimahefa (2012) 20%, 41%, 42% (after 1, 4, 8 quarters)
(SSA), 19852008Q2
Kohlscheen (2010) 5%, 17%, 20%, 24% (after 3, 6, 9, 12
(8 emerging floaters), Float samples (see our months)#
Exchange Rate Pass-Through in Developing and Emerging Markets 127

Table 1)

(continued )
Table 2. (Continued)

Study, sample and period Advanced countries Developing countries Emerging countries

Akofio-Sowah (2009) (For SSA) (For LA)


(SSA/LA), 19802005 (max.) 38% for CFA and 12% for CMA 19% unofficially dollarised; 4% for
and 20002005 for LA (1 quarter) fully dollarised (1 quarter)
128 J. Aron et al.

CaZorzi et al. (2007) (For G3: US, Japan, Euro area) (For 12 markets incl. China)
(12 emerging), 19752004Q1 (max.) 1%, 2%, 7% (4 quarters each) 24% (4 quarters)
2%, 4%, 13% (8 quarters each) 45% (8 quarters)
Choudhri and Hakura (2006) (after 1, 4, 20 quarters) (after 1, 4, 20 quarters) (after 1, 4, 20 quarters)
All 71 countries, 19792000: 12%, 20%, 23% 15%, 24%, 27% 14 %, 24%, 27%
By low inflation sets: 8%, 14%, 16% 12%, 18%, 22% 9%, 14%, 17%
By moderate inflation sets: 24%, 39%, 42% 19%, 33%, 35% 18%, 33%, 35%
By high inflation sets: None 30%, 46%, 52% 34%, 52%, 59%
All 71 by inflation regimes: (after 1, 4, 20 quarters)#
8%, 14%, 16% (low inflation regime):
19%, 33%, 35% (moderate inflation)
32%, 50%, 56% (high inflation)
Goldfajn and Werlang (2000) 25% (after 6 months) 34% (after 6 months) 39% (after 6 months)
(71 countries), 198098 (max.) 61% (after 12 months) 51% (after 12 months) 91% (after 12 months)
(For OECD/non-OECD, contains (DEM: for developing or emerging except for Denmark and Belgium)
Turkey)
19% (after 12 months) 75% (after 12 months)
11% (after 6 months) 47% (after 6 months)

Notes: 1. The advanced economies benchmarks come with the caveat that biases may be present: both exclude long-run terms in a differenced reduced-form equation that
assumes exchange rate exogeneity.
2. Averages: # is the quoted un-weighted average from study; is the quoted panel estimate from study; is our calculated average (un-weighted) for this survey.
3. See online Appendix 2 for constituent countries in advanced, emerging and developing categories. For Choudhri and Hakura (2006) we allocate as follows: low income+
lower-middle (as developing); upper-middle income (as emerging), which allows near coincidence with the Emerging Markets Index list of emerging countries; and
advanced countries (using the World Bank classification).
4. Brun-Aguerre et al.: their models a, b, c, (for unbalanced panel); equilibrium for model b. is actually five-quarter ERPT (see our Table 1). Kohlsheen: plus output in the
reported VAR. Frankel et al.: Equation 1 with ecm and exporters costs (in their Tables 8 and 10). Gagnon and Ihrig use an approximation for the long run: dividing by (1-
coefficient on the one-quarter lagged dependent variable) in a differenced model for criticism see online Appendix 1. Note that Choudhri and Hakura (2012) is a bivariate
VAR without controls, and some ERPT estimates have huge standard errors.
5. **See Sections 6.2 and 6.4 for discussion of data and execution errors.
Exchange Rate Pass-Through in Developing and Emerging Markets 129

Table 1. Using single equations, Bussire and Peltonen (2008) report a range for ERPT to import
prices after 1 quarter of 15 per cent (Taiwan) and 26 per cent (Columbia) to above 70 per cent
(Mexico); and for export prices, of 19 per cent (Malaysia) to 72 per cent (Thailand) and 90 per cent
(Brazil). The various systems models in Table 1 also exhibit country diversity for import prices. For
consumer prices, the EPRT after a year ranges from 913 per cent (Burundi and SA) to 4850 per cent
(Hungary, Jamaica and Venezuela) for moderate inflation countries using single equations (Choudhri
& Hakura, 2006). The diversity is confirmed by systems studies in Table 1; for example, in CaZorzi,
Hahn, and Snchez (2007), the ERPT after one year ranges from below 10 per cent (Argentina, China,
Hong Kong, Singapore and Taiwan) to over 30 per cent (Chile, the Czech Republic, Hungary and
Poland).
Finally, the extreme forms of LCP or PCP have sometimes been tested for. For the OECD, Campa
and Goldberg (2005) find local currency pricing can be rejected for 20 of the 23 countries in the short
run and for 18 of 23 in the long run. Producer currency pricing can also be overwhelmingly rejected in
the short run (22 out of the 23 countries), but in the long run is harder to reject (7 of the 23 countries).
Razafimahefa (2012) tests for zero ERPT (restricting the coefficients on the exchange rate to zero) and
complete (short-run) ERPT (restricting the coefficients to 1) in a bivariate differenced VAR study
(though with only 12 quarterly lags and no controls; see Table 1). She rejects the restrictions and
hence the implied extreme forms of LCP or PCP for sub-Saharan Africa (SSA) as a whole.

6.2. Comparisons of ERPT for the Same Country across Different Studies
There are striking differences in the measures of ERPT in different studies for the same country. This
is illustrated with SA, often the sole African country in multi-country studies and widely studied at a
single country level. Table A1 shows, for different methodologies, that after one year the elasticities
range for ERPT to consumer prices is 1245 per cent. Of these, the four systems studies (even with
few controls) are more reliable given feedback effects, and suggest an average of about 17 per cent.
This approaches single equation estimates of 18 per cent ERPT after one year (30 per cent after two
years) found by Aron, Farrell, et al. (2014), and 1523 per cent (goods) and 3037 per cent (services)
after two years found by Parsley (2012), both using disaggregated data and better controls (Table A1).
Two long-run equilibrium studies cover pre-2000 data, but in lacking key controls and violating long-
run price homogeneity, the results may be unreliable.
For import prices, the estimates are diverse and include some incredible results. Equilibrium
measures range from 55 per cent for a systems study (Aron, Farrell, et al., 2014) with long-run
homogeneity satisfied (and agreeing with an estimate of 60 per cent by Parsley [2012] using
disaggregated import data), to an unrealistic 230 per cent for Brun-Aguerre et al. (2012) (explained
by a data construction error39). For short-run measures, the ERPT is 46 per cent after a year for a
single equation in Aron, Farrell, et al. (2014) and somewhat less in their systems study (Table A1).
Aron, Farrell, et al. control for domestic unit labour costs, important in SA as a moderately high
inflation country with powerful trade unions and volatile inflation rates. Ignoring wage shocks
potentially exaggerates the role of the exchange rate.
The sensitivity of these results, for the same country over a similar period of time, underlines the
importance of including appropriate controls and satisfying the theoretical long-run price homogeneity
restrictions, and of robustness testing of lag structure, model specification and the included proxies for
the theoretical controls.

6.3. Differences of ERPT across Groups of Countries


Several studies report that they have overturned an earlier consensus that the ERPT to prices tends to
be much greater for emerging markets than advanced economies (Brun Aguerre et al. 2012; CaZorzi
et al. 2007; Kohlscheen 2010; Bussire & Peltonen 2008). This result is potentially important in
emerging markets because a lower ERPT suggests that the fear of floating may have been exagger-
ated in these countries.
130 J. Aron et al.

The earlier quoted results do not offer a rock-solid benchmark: they are Goldfajn and Werlang
(2000) covering 198098 (see Table 1); and Calvo and Reinhart (2000), covering short floating
samples mainly in the 1990s with a bivariate differenced VAR. They pre-date inflation targeting for
many emerging market countries (when inflation and ERPT fell), while more recent studies span at
least two monetary regimes with an unstable ERPT coefficient (see Section 6.6). Both neglect controls
for destination and foreign costs: yet these are especially important in inflation-prone emerging
markets. The exchange rates role is thus exaggerated in these studies. The country samples differ
too; there are more advanced emerging economies with lower inflation (for example, Hong Kong) in
the above-quoted recent studies (Table 1).40
Regardless of the overturning of a conventional wisdom, our surveyed studies indeed find
comparable ERPT measures to both trade prices and the CPI for emerging and advanced countries,
controlling for inflation regimes and the heterogeneity of ERPT across countries. Table 2 tabulates the
available results by country group. The differential between advanced and emerging country groups
rises: when the low inflation period after 2000 is excluded; when very high inflation emerging
countries are included; when the emerging sample excludes advanced emerging countries; and, we
argue, when destination cost controls are absent. Choudhri and Hakuras (2006) results suggest that the
ERPT to CPI is similar for low and moderate inflation countries41 by group even before 2000.
CaZorzi et al. (2007) confirm that emerging markets with one-digit annual inflation rates (notably
the Asian countries) have a low ERPT to CPI, not dissimilar from the developed economies.
Is the ERPT for the group of developing countries higher than for the emerging market countries?
Only one study explicitly compares advanced, emerging (24) and developing (28) country groups
(Goldfajn & Werlang, 2000). They find that ERPT to the CPI after six and twelve months is higher for
emerging markets than for both the advanced and developing countries over 198098. But this result is
driven by the high inflation Latin American countries in their emerging sample (Table 2 and their
Table A2). We created group averages from the 71 countries in Choudhri and Hakura (2006) by
inflation regime. This suggests that for each of the low, moderate and high inflation regimes, the
developing and emerging groups have a similar ERPT to CPI, up to 20 quarters (Table 2). Moreover,
simple averaging after separating out emerging countries from 24 developing countries in Barhoumi
(2006), also suggests that the equilibrium ERPT to import prices is similar for developing and
emerging groups (and comparable to the panel measure for the combination of the two).
Both Akofio-Sowah (2009) over 19802005 and Razafimahefa (2012) over 19852008 consider
SSA countries (that is, mainly developing countries), but their different (panel) methodologies
compromise comparability. The latter (with no controls,42 see Table 1) estimates ERPT to CPI for
SSA after four and eight quarters as around 40 per cent, by a simple average of individual countries
ERPT. Akofio-Sowah distinguishes among currency groups, and ERPT to CPI after one quarter ranges
from about 60 per cent to as low as 12 per cent for the more credible unions.43 To conclude, the
comparison across groups depends on the average inflation of the included countries and the period
over which ERPT is measured (we show below it is unstable with changes in monetary regimes). The
set of advanced countries should be broader than just the G3 (which exhibit extreme differences for
ERPT to import prices; see Table 2). Panel studies force the ERPT to be homogeneous across the
group measured: but this restriction is soundly rejected by the data (see Barhoumi, 2006), so the results
are unreliable if applied to individual countries.

6.4. Macro versus Micro Drivers of ERPT


Many studies follow Campa and Goldberg (2005) and McCarthy (2007) in exploring whether the
drivers of ERPT are predominantly micro- or macro-economic in origin. These groups of determi-
nants reflect the two strands of literature referred to in Section 1: the industrial organisation models
and pricing behaviour of firms; and nominal rigidities. Evidence supports both micro- and macro-
effects; some more important for emerging markets than advanced countries, but with several
commonalities.
Exchange Rate Pass-Through in Developing and Emerging Markets 131

Simple correlations are often reported, which are suggestive.44 Bussire and Peltonen (2008) run
cross-sectional regressions of ERPT estimates on macro-variable drivers: the averages and standard
deviations of both inflation and changes in the NEER over the sample; and micro-variable drivers: the
share of high tech imports and import dependence. Bivariate regressions find that a higher domestic
inflation average, inflation volatility and exchange rate volatility imply higher export price and import
price elasticities.
No significance is found for country size effects45 or product differentiation (which may be due to
poor proxies or offsetting theoretical effects). In multi-variate regressions including all macro- and
micro-factors, only foreign exchange variability is significant, raising ERPT. This is probably due to
multicollinearity across the variables. The multi-variate result accords with our interpretation below on
invoicing issues. High relative exchange rate variability in emerging markets may induce foreign
currency invoicing by exporters, thus raising ERPT.
There are more controls in the panel analysis of Brun-Aguerre et al. (2012), who regress five years
(2004Q32009Q3) of ERPT estimates from rolling window estimations, controlling for country and
time fixed effects, on the following drivers: forex variability, long-run average inflation, exchange rate
asymmetry effects and the output gap (macro); and relative wealth, import dependence, tariffs
(designated micro). The data errors (see Section 6.2) resulting in erroneous elasticity estimates for
South Africa contaminate the panel results. More seriously, there are problems with the execution of
the rolling window analysis.46 Thus, these results are not reliable.
Frankel, Parsley, and Wei (2012) also conduct a comprehensive study of factors influencing the
ERPT to disaggregated prices and the CPI using sequential additions of interaction effects with both
the et and the ecm terms. (The uninteracted terms are not included in the regression so are absorbed
into the fixed effects.) The CPI equation does not include domestic cost controls. Examining results for
emerging markets only (the column with Equation 7 in their Table 10) a downward trend over the
sample ceases to be relevant when controlling also for long-term inflation (not significant) and forex
variability (significant); the ecm itself is not significant. However, the coefficient on the et term in
these regressions cannot be interpreted because the variables that are crossed with the exchange rate do
not have a mean of zero across the sample (they should be de-meaned in this exercise because
differences in units compromise the original ERPT coefficient). The sequential addition is also a
specific-to-general approach sensitive to the order in which variables are added and so restrictive
compared to a general-to-specific approach.

6.5. Asymmetries in Pass-Through


Departing from linearity, and testing for size and directional asymmetries in ERPT, is novel in
emerging market research. In advanced countries, significant asymmetries are found (Pollard &
Coughlin, 2003) on United States industry-level data; Campa and Goldberg (2008) in the EU; and
Bussire (2007) in the G7 economies). But of the multi-country studies surveyed in Table 1, only
Razafimahefa (2012) and Mihaljek and Klau (2008) examine asymmetry for consumer prices, and
Brun-Aguerre et al. (2012) for import prices. Asymmetry is found (though see the caveats below).
Razafimahefa (2012) interacts a dummy for depreciation episodes with et to examine directional
asymmetry, and finds more pronounced ERPT following depreciation than appreciation; however the
method restricts ERPT to be the same for all of SSA47 and uses a bivariate VAR without other
controls. Mihalek and Klau (2008) include individual dummies, without interaction, for periods of
depreciation and appreciation; and, separately, dummies for all exchange rate changes greater than 5
per cent over one quarter to capture threshold effects. Few significant effects are achieved.
There is also evidence from single country studies with threshold effects; for example, see Aron,
Farrell, et al. (2014), who distinguish size and directional asymmetries. They also consider invoicing
switches following extreme exchange rate volatility. A switch to foreign currency invoicing may also
help explain the Indonesian experience (Ito & Sato, 2008): after five years of volatile exchange rates,
ERPT was markedly higher in Indonesia than in Korea, Malaysia, the Philippines and Thailand. The
size of depreciations in Indonesia from 1997 far exceeded those of the other countries. This might
132 J. Aron et al.

suggest a non-linear response typical of menu costs. The volatile currency may have induced a switch
from domestic to foreign currency invoicing, raising ERPT. Ito and Satos interpretation is that
Indonesias (nominal) monetary base reacted strongly to the (nominal) exchange rate.

6.6. Exchange Rate Volatility and Invoicing Currency Switches


If exporters are faced with high exchange rate volatility in the destination country, ERPT elasticities
could be raised should exporters stabilise their profit margins by invoicing in their own currency
(Dhring, 2008; Gopinath, Itskhoki, & Rigobon, 2010). This might be important in emerging markets
where fewer hedging instruments are available. Alternative arguments based on competition and menu
costs reach the opposite conclusion (see Section 1). But the relatively higher volatilities in emerging
markets as against advanced countries might favour the first argument, and so it turns out. The uniform
result from Table 1 is that the ERPT to aggregate consumer, import and export prices rises with
volatility.
Various short-term measures are used; for example, the standard deviation of daily, monthly or
quarterly log exchange rate changes (though some are not precise about the period over which
volatility is measured). For the CPI, the panel study of Akofio-Sowah (2009) interacts the change
in volatility with the current et , controlling for currency groupings; the ERPT is higher for SSA (the
interaction term is barely significant for Latin America). Choudhri and Hakura (2006) regress current
and 20-quarter ERPT elasticities for all countries on volatility, controlling for other drivers. Average
inflation dominates all drivers, but in their bivariate regressions the volatility shows up positive and
significant.
For trade prices, Brun-Aguerre et al. (2012) pool their time-varying ERPT elasticities in a panel
regression of drivers including foreign exchange volatility, but as noted in Section 6.4 their analysis is
not reliable. CaZorzi et al. (2007) derive Pearson product moment correlations between ERPT import
elasticities and exchange rate volatility, finding positive and significant correlations at both the first
and second year horizons In simple bivariate panel regressions, Bussire and Peltonen (2008) find that
higher exchange rate volatility is associated with higher ERPT to both export and import prices (after
one quarter). Kohlscheen (2010) with Spearman correlations also finds for emerging floaters that
increased exchange rate volatility is associated with higher 6- and 12-month ERPT.
However, employing a longer-term variability measure (the standard deviation of monthly exchange
rate changes over the preceding five years), Frankel et al. (2012), for individual countries and panel
groups of developing and high income countries, find higher volatility associated with lower ERPT in
rich countries but the opposite in developing countries. It may be that exchange rate shocks are
perceived to be mainly temporary in rich countries and mainly permanent in developing countries
(Froot & Klemperer, 1989).

6.7. Instability in Pass-Through from Regime Change


A different kind of non-linearity is introduced if the ERPT parameter, , in Equation (8) is not constant
but varies by regime over the sample. For linear models spanning different regimes in long samples
robustness testing is necessary. There is a sizeable literature examining changing ERPT in the sample
for advanced economies (Campa & Goldberg, 2005; Gagnon & Ihrig, 2004). For emerging markets,
studies in Table 1 explore unstable ERPT in: fixed versus flexible exchange rate regimes; high,
moderate and low inflation regimes; liberalised trade regimes; and monetary policy regimes (for
example, adoption of inflation targeting). Several techniques are used (see Section 4.1).

6.7.1. Exchange rate regimes. The exchange rate regime is not irrelevant for macroeconomic per-
formance, despite the mirage of fixed rates and the fear of floating, Klein and Shambaugh (2008)
argue. They demonstrate that de facto48 fixed exchange rates exhibit considerably greater bilateral
exchange rate stability than flexible rates, controlling for country and year fixed effects, inflation
behaviour and capital controls.49 A less volatile regime is more likely to encourage invoicing in the
Exchange Rate Pass-Through in Developing and Emerging Markets 133

destination countrys currency (Sections 4 and 5) and pricing-to-market from foreign exporters; hence
the prediction is for lower ERPT under fixed regimes. On the other hand, a shift in an exchange rate
peg is more likely to be perceived as a permanent shock, so resulting in higher ERPT.
In Table 1, studies comparing fixed versus flexible regimes run up against problems defining the
regimes for their countries. Barhoumi (2006) sub-groups countries by exchange rate regime, 1980
2000, using the purely statistical method of Levy-Yeyati and Sturzenegger (2005); Razafimahefa
(2012) classifies into flexible and fixed groups over 19852008 using the IMFs Annual Report
on Exchange Arrangements and Exchange Restrictions. Both classifications are sometimes at odds
with the de facto institutional classification of Reinhart and Rogoff (2004). Moreover, different
regimes per country are spanned within the sample period. In several cases, part of the floating regime
also coincides with the adoption of inflation targeting, when inflation stabilised and declined. The
result from both studies, that fixed regimes have higher ERPT than flexible regimes (in the long-run
for Barhoumi and after 1 year for Razafimahefa), may not be reliable, therefore.50
Others isolate an exchange rate regime. Kohlscheen (2010) confines attention to floaters, defining
the regime-periods using Reinhart and Rogoff (2004); Ito and Sato (2008) largely confine analysis to
the post-Asian crisis period for five countries; and Bussire and Peltonen (2008) find dummies for
exchange rate crises are important in their regressions, reducing differences in ERPT estimates
between advanced and emerging market countries.

6.7.2. Monetary regimes. For advanced countries, the relationship between monetary policy regimes
and ERPT has been widely examined. In Table 1, support for a positive and significant relationship
between ERPT and average CPI inflation emerges strongly for emerging markets, and explains most of
the ERPT differences between them and advanced economies.
The most-quoted study of the effect of inflation on ERPT is by Choudhri and Hakura (2006). The
ERPT estimates to CPI for 71 countries are segregated into low, moderate and high inflation regimes
(see Section 6.3). Pearson and Spearman rank correlations show that, in cross-sections, ERPT in the
different regimes (for horizons up to 20 quarters) is positively and significantly related to the average
inflation rate and the variance of inflation. This holds across countries and within countries. At each
horizon, average ERPT is lowest for the low inflation group and the highest for the high inflation
group. When the average exchange rate and its variance are included in the regressions, the average
inflation rate dominates.
Similar cross-sectional results for short-run ERPT, but without segregating inflation regimes, are
found by CaZorzi et al. (2007) and Bussire and Peltonen (2008).51 CaZorzi et al. find for 10
emerging markets that four- and eight-quarter ERPT to CPI is inflation-dependent (a result robust to
the identification in the VAR generating the ERPT estimates). Bussire and Peltonen (2008), in
bivariate regressions for 41 emerging countries, find the inflation average and volatility are positively
associated both with a higher export price ERPT and a higher import price ERPT (one quarter
horizon). For equilibrium ERPT for imports, Barhoumi (2006) finds marginally higher elasticities
for those amongst the 24 developing countries with high inflation regimes.
The before-and-after method is adopted by Coulibaly and Kempf (2010), who separate monetary
regimes by date of adoption of inflation targeting for 27 emerging markets (with some non-targeters).
In a panel-VAR, the rate of ERPT falls for all three price indices (import, producer and CPI) after the
institution of more credible monetary regimes for the 15 targeters.52 Moreover, the contribution of
exchange rate shocks to price fluctuations declines after the adoption of inflation targeting, unlike in
the control group of non-targeters.53 Choudhri and Hakura (2012) estimate heterogeneous (bi-variate)
VARs for ERPT to import and export prices, but find no decline in their emerging market sample for
data from 1998 to 2010, compared with 19851997.
Several studies use interaction methods, with similar findings.54 Akofio-Sowah (2009) interacts et
with currency group dummies in SSA in a regression for CPI inflation. Higher ERPT is found for
currency groups where average inflation is highest (the COMESA group of countries) compared with
other regional currency groups, suggesting the latter are more credible. For Latin America, he finds
ERPT is lower for officially dollarised countries (or with moderate unofficial dollarization), than for
134 J. Aron et al.

unofficially dollarised economies. In Razafimahefa (2012), a general post-1997 dummy is interacted


with et in a panel regression for CPI inflation in SSA, and the ERPT falls in the lower inflation
period beyond 1997 (Figure 1).55
Finally, monetary aggregates and/or interest rates have been added in several VARs (for example,
CaZorzi et al., 2007; Ito & Sato, 2008). These extensions of the VAR tend to support the Taylor
hypothesis, that an anti-inflationary monetary policy regime is associated with lower ERPT.

6.7.3. Trade policy liberalisation. The less advanced countries have experienced extensive trade
policy liberalisation in recent decades. The ERPT will be unstable in long samples if it depends on
trade policy. Theory supports a negative relation between openness and inflation (Romer, 1993). The
impact of trade liberalisation on ERPT is less clear. Tariffs and quotas restrict spatial price arbitrage,
violating the law of one price (Channel 3, Section 1). Liberalising reduces the cost barriers to
arbitrage, increasing the integration of markets. Prices become more sensitive to costs, which increases
ERPT.56 In the Cournot model of Dornbusch (1987) see Section 1, more competition increases ERPT,
as does a greater foreign share of imports (that is, greater import penetration and a paucity of local
substitutes). But if the trade composition evolves with liberalisation towards more differentiated goods
(for example, from homogeneous commodities to manufactured goods) with lower ERPT, average
ERPT may fall (see Campa and Goldberg [2005] for the OECD). In emerging markets, the scale of
past tariff and quota reductions could overwhelm such an effect, and Chinas WTO entry in 2001 will
have increased the share of mass-produced standardised imported products.
Trade liberalisation refers to lifting of tariff and/or non-tariff barriers. Proxying actual trade policy is
fraught by measurement problems, especially for unobservables such as quotas, once widely used in
SSA. Measures of average tariffs are sometimes used though the data are infrequent (and exclude
quotas and non-tariff barriers). The ubiquitous empirical measure for openness (import dependence
or penetration) is trade flows to GDP in real or nominal terms;57 but it is endogenous and influenced
by many factors, including country size. The direct impact of trade policy or openness on inflation is
captured by including an empirical proxy in an ERPT regression; the impact on the ERPT itself is
measured by interacting the proxy with et in this regression, or more directly by cross-sectional or
panel correlations or multi-variate regressions of ERPT estimates on the proxy and other variables.
The effect of reducing protectionism on the equilibrium ERPT to import prices is examined by
Barhoumi (2006). Countries are segregated by trade protection regime using tariffs. This author is one
of the few who tests the assumption of homogeneity of long-run ERPT across countries assumed by
pooling. He rejects the hypothesis. For pooled and non-pooled mean groups methods, lower tariff
barrier countries indeed experience a higher equilibrium ERPT to import prices than higher tariff
barrier countries. For short-run ERPT, cross-sectional correlations and regressions mainly fail to find
the expected positive relationship between ERPT and trade-openness using the trade flows proxy
measures (Section 5). Kohlscheen (2010) finds a strongly negative correlation of ERPT to CPI with
trade-openness for floaters (but does not control for inflation). CaZorzi et al. (2007) find negative
correlations with trade-openness for four- and eight-quarter ERPT to CPI that are not statistically
significant, but a positive link, also insignificant, after controlling for inflation. Using regressions,
Choudhri and Hakura (2006) find no significant link with an import to GDP ratio, without and with
inflation, for current- and five- year ERPT elasticities. Bussire and Peltonen (2008) find the same
result, and similarly for the degree of product differentiation (proxied by the share of high-tech goods
in total trade flows).
Ambivalent results for the CPI are achieved by Goldfajn and Werlang (2010) using the indirect
method. Interacting trade flows and et produces the expected positive sign and significance within a
year (important for the Africa group), but the direct openness term has the wrong sign, and results
prove sensitive to the horizon and sample.58 Frankel et al. (2012) interact two variables with et : trade
flows and a proxy for tariff barriers (using tariff data, available for two years in the sample). Higher
barriers apparently reduce ERPT to the CPI for all 71 countries (as in Barhoumi [2006]); the effect
disappears on adding the interaction with average inflation. For the group of developing and emerging
Exchange Rate Pass-Through in Developing and Emerging Markets 135

market countries, the barrier effect reverses and is significant (when controlling also for interaction
effects with trade flows, average inflation and exchange rate variability).
In a nutshell, the different studies suggest: (1) lowering the trade barrier (measured by tariffs) to
price arbitrage raises ERPT in the short run and also at equilibrium for some prices; (2) in more open
economies (alternatively, more import-dependent/with greater import penetration/with a greater num-
ber of importers relative to domestic producers), the ERPT to both import prices and the CPI is raised
when controlling for average inflation, but this effect is not always significant. The results are sensitive
to the sample used.

7. Micro-Price Analyses with Heterogeneous Pass-Through


The studies surveyed in Section 6 concentrated on aggregate price indices. Aggregate data offer two
distinct advantages. Underlying the aggregate indices are millions of micro-prices, and the hetero-
geneous weights applied to them, being derived from consumer price surveys (for example, for the
CPI) and regularly updated, reflect their economic relevance. By contrast, the disaggregated price data
studies usually aggregate with equal weights for simplicity, and often for a subset of prices that may
not be the most intensively used. The resulting aggregate is thus not closely connected with the key
concerns of monetary policy-makers. A second important advantage is that with time series of
aggregate price indices, a systems approach can help disentangle exogenous shocks from changes in
the exchange rate, and hence address the monetary policy feedback effects in ERPT relationships. This
is missing in micro-analyses (see below). Against these advantages, there is likely to be an aggregation
bias in ERPT given the consistent evidence for large and persistent heterogeneity in sectoral and goods
levels price adjustments: service prices are stickier than goods prices, and raw goods prices are more
flexible than processed goods (Klenow & Malin, 2011). Imbs, Mumtaz, Ravn, and Rey (2005) expect
heterogeneity from the differing tradability of goods, degree of competition and transportation costs in
different sectors, and adjusting for the observed bias helps solve the PPP puzzle (Rogoff, 1996), at
least in their dataset.
ERPT has been intensively studied using disaggregated trade prices at industry, firm and product
levels, mainly for industrialised countries. Even in Menons 1995 survey, almost half the studies on
import price pass-through used disaggregated industry data, and a handful at the product level. More
recently this relative prevalence has been facilitated by standardised international definitions of traded
goods,59 and this literature is surveyed by Goldberg and Knetter (1997). As noted by Goldberg and
Campa (2010), these studies encompass: more aggregated cross-sectional industry studies; subsets of
narrowly defined industries; and firm/product micro-studies that tend to focus on a product or industry.
A disaggregated analysis to the product level using annual unit value trade data for the 1990s, and
including emerging and developing countries, is by Frankel et al. (2012). The study pools 8 specialised
commodities (details in Table 1), 12 years and 76 countries, using product and country dummies
(pooled using equal weights). The downward trend in ERPT to the pooled goods prices may be partly
related to the monetary regime (interacting long-term inflation and exchange rate variability with et ).
Real wages in interaction effects are also relevant, reflecting the role of distribution and retail costs in
the decline in the ERPT.
A new, burgeoning strand of research examines pricing behaviour with highly disaggregated
consumer price, producer price and trade price data. Most of the small body of research pertains to
the United States and euro area (surveyed in Klenow & Malin, 2011; Melick & Galati, 2006). Data
sets underlying the official monthly CPIs and PPIs have become available; as well as weekly scanner
(barcode) data and daily data from web-based retailers. In the United States, micro-data underlying
monthly import and export price indices are now provided by the Bureau of Labor Statistics
(originating from surveys of firms). However, only a small subset of this research examines ERPT;
for example, using US micro-trade prices (summarised in Gopinath, 2012), United States retail and
wholesale coffee prices (Nakamura, 2008; Nakamura & Zerom, 2010) and beer prices (Hellerstein,
2008).
136 J. Aron et al.

To our best knowledge, no published studies for emerging market countries examine ERPT to
micro-price data underlying the CPI (the first is Aron, Creamer, et al. [2014]). Some studies examine
ERPT to the main sub-components of aggregate price indices such as the PPI or CPI covering brief
time periods (for example, 31 components in Soffer [2006]).60 Parsley examines ERPT with partly
disaggregated retail price data from the Economist Intelligence Unit (EIU) for emerging markets (for
example, Parsley, 2012). Finally, a recent strand of the forecasting literature forecasts sectoral inflation
for sub-components of the CPI, giving insights into ERPT.61
The key findings from the micro-data studies for industrial countries on ERPT are:

Heterogeneous ERPT estimates are typically reported at the sectoral and goods levels, and ERPT is
delayed and incomplete for imports and both retail and wholesale domestic prices.
Those adjusting import and export trade prices frequently have a far higher medium-run ERPT
than low-frequency adjusters (Gopinath & Itskhoki, 2010). United States sectors producing
homogeneous goods (for example, raw products) mainly price in dollars and adjust prices more
frequently than product-differentiated sectors, which are mainly non-dollar-priced (emphasising
that choice of the invoicing currency is endogenous; see Gopinath and Itskhoki [2010]). The
macro-level implications are clear if the trade composition should adjust towards differentiated
goods.
For destination country retail and wholesale prices, together non-traded local costs and imported
inputs are the most important source of incomplete ERPT, estimated to contribute 5078 per cent
to incomplete ERPT across industries as diverse as beer, coffee and automobiles. It is difficult to
distinguish empirically between these factors using micro-data approaches (Goldberg &
Hellerstein, 2008). Studies using alternative methodologies and more aggregated data reach similar
conclusions (Burstein et al., 2003; Goldberg & Campa, 2010). The latter suggest that the greater
use of imported inputs in traded and non-traded goods across countries and industries is the key
contributor to changing ERPT, not changes in distribution margins.62
Mark-up adjustment accounts for most of the rest of incomplete ERPT (for example, reduces
ERPT by 33 per cent [after six quarters] in Nakamura and Zerom [2010] relative to a constant
elasticity benchmark; and by manufacturers and retailers, by about half in the long-run in
Hellerstein [2008]).
The role of nominal price rigidities in incomplete ERPT appears small in the longer run but is
important in the delayed response of prices to cost in the short run (Nakamura & Zerom, 2010).
Rigidity seems to occur mainly at the wholesale and not retail level; strategic complementarities in
pricing are small for their model (see a similar view in Klenow and Malin [2011]).

A caveat is needed as restricted structural models were used for these studies. The ERPT may be
biased for the usual reasons; for example, the static single equation approach63 misses dynamic price-
adjustment and may overestimate the role of local costs; more generally, assuming exogeneity of the
exchange rate neglects monetary policy and other feedback effects.
Studies at the level of industries, firms, products or retail goods potentially lend insight into
underlying structural price adjustments and the sources of incomplete and changing ERPT. As
indicated by Bailliu and Murray (2010), this promising research area could assist in forecasting future
patterns of ERPT of interest to monetary policy-makers (and should include emerging markets).

8. Conclusions for the Wary Policy-Maker


We surveyed recent literature on ERPT, focusing on developing and emerging market (DEM)
countries. It is salutary to reassess the major areas of concern in Menons comprehensive survey of
1995. The stark imbalance in country coverage has been redressed with a growing literature on DEM
economies in multi- and individual-country studies. The profession now largely uses methodologies
that address the non-stationary nature of the underlying time series, the changing coefficients of ERPT
Exchange Rate Pass-Through in Developing and Emerging Markets 137

in time and, increasingly, asymmetries in ERPT. There is continued widespread use of often unsa-
tisfactory price proxies such as unit values (see data discussion in Section 5); the trend to studying
aggregated price indices has increased in the last decade, given the monetary policy interest, but a new
focus on EPRT with underlying micro-prices is set to grow as datasets become available (Section 7).
Menons concern that choice of data and methodology significantly affects the reliability of published
ERPT estimates is heavily reinforced by our survey. Lessons are presented to improve future research
and guide policy-makers.
The key finding of this survey is the generally poor state of the empirical literature for DEM
countries, leading mainly to inconclusive and often incomparable results on ERPT (illustrated for a
single country, South Africa, in Section 6.2). In general there are five common mis-specifications
contributing to the malaise. First, many multi-country studies ignore the country heterogeneity (except
in country fixed effects) that arises from different levels of development and trade regimes, different
monetary policies and histories of inflation, and differences between commodity exporters and
commodity importers. Thus, before restrictions are imposed that ERPT coefficients are the same
across all countries in the sample, these restrictions should be tested.64 A second common error,
particularly in multi-country studies, is to specify a highly restricted bivariate relationship between, for
instance, import prices and the effective exchange rate when the relationship is multivariate, for
example involving domestic costs, such as unit labour costs, and foreign prices, possibly including
oil prices. A third common error is to assume very restrictive lag structures without careful testing
(often when using information criteria in VARs; see further discussion in online Appendix 1). For
example, the assumption of short lags and the omission of domestic unit labour costs (which are slow
to adjust to shocks but eventually respond to imported inflation) could result in long-run ERPT being
substantially under-estimated. However, in countries where powerful unions create domestic wage-
push shocks which depreciate the exchange rate, there is a risk of over-estimating the impact of the
exchange rate on domestic inflation. This example takes us to the fourth frequent mis-specification,
which is to ignore the potential endogeneity of the exchange rate, and of domestic cost variables, when
these are included. Particularly when active anti-inflationary monetary policy is operating, it seems
likely that an initial exchange rate shock will be partly offset by an interest rate adjustment, leading to
negative feedback of exchange rate shocks, and so reducing the longer term inflationary impact of the
initial shock. Notably, these issues are almost invariably ignored in ERPT studies on micro-data. The
important implication is that equation systems are needed to develop a deeper understanding of ERPT.
The shift in monetary policy regimes also illustrates a fifth potential mis-specification linked with
the importance of non-linearities in DEM economies: the assumption of constant parameters, when
structural breaks from regime changes shift the coefficients underlying the time profile of ERPT. To
date, we are not aware of studies for emerging markets combining a systems approach with tests for
structural breaks that potentially could occur anywhere in the equation system. The possibility of
structural breaks is part of the reason why many researchers work with VARs or single equations
specified for data in quarterly or monthly differences. For estimation of short-run ERPT or short-run
forecasting, differencing the data is likely to improve robustness; but, to estimate medium-term ERPT
robustly, which is arguably the time frame of most interest to monetary policy-makers, model selection
strategies that test and control for breaks are needed (see Castle, Doornik, and Hendry, 2012).
Where does this leave the policy-maker? Given the pervasive empirical mis-specifications in the literature
on ERPT in DEM countries, one can ask what stylised empirical facts emerge, apart from the obvious ones
that short-run ERPT is smaller than long-run ERPT, that ERPT diminishes down the distribution chain from
import prices at entry to consumer prices, and that there is considerable heterogeneity among countries. One
important stylised fact is that there appears to be little systematic difference between advanced countries and
DEM economies as a whole, once inflation history is controlled for. This is consistent with the view that
ERPT has declined with more stable, anti-inflationary monetary policy regimes (see Taylor, 2000). However,
though not investigated by our studies, technical change, changes in trade composition, the China effect on
inflation in manufactures and the increasing CPI weight of services could also account for some of this effect.
There are some indications that exchange rate volatility may be associated with higher ERPT in the
DEM countries with floating currencies, possibly because exchange rate changes are viewed as more
138 J. Aron et al.

permanent or because invoicing in DEM currencies is discouraged by volatility. However, in countries


with occasionally shifting currency pegs, which tend to have lower exchange rate volatility, ERPT
appears to be higher, probably again because exchange rate changes are viewed as more permanent. At
this stage, we view the evidence on asymmetries in the response of domestic prices to positive/
negative or large/small exchange rate shocks as too inconclusive and too sensitive to the specification
errors in the underlying models for broad conclusions to be reached. Similarly, evidence on trade
openness (import penetration) analysed using (endogenous) trade flows is ambiguous, though lower
trade barriers measured using tariff measures appear to increase ERPT.
Fresh research work should concentrate on addressing the empirical deficiencies highlighted in this
survey: comparing single equation and systems methods given their comparative advantages and
disadvantages (Section 4.3); checking robustness to different empirical proxies and lag lengths in
better-specified equations using general-to-specific approaches, and to variable ordering (in VARs);
taking account of the non-linearities and regime changes that prove pervasive in DEM economies such
as monetary and trade regime changes (implying instability in ERPT) and asymmetries of various
types. A high priority for research on aggregate time-series data for DEM countries is to incorporate
domestic costs in the form of unit labour costs. Such data for the aggregate economy are often
unavailable, but for many countries there are data on wage rates, at least for some sectors of the
economy and on productivity growth, even if only annual data. Unit labour costs could then be
replaced by hourly or per person wage or earnings data and the productivity trend, without enforcing
the restriction: log ULC log wage  log productivity: But this needs to be studied in at least a
three-equation system, in which domestic prices, wages and the exchange rate are treated as endo-
genous, and where, for small economies, foreign prices including oil prices are taken as exogenous.
Where highly disaggregated micro-data are becoming available, studies of ERPT and of the frequency
of price changes are a high priority. Such studies illuminate the effects of market structure and recent
price history on current price setting and hence on the economics of inflation.
For the wary policy-maker, forewarned is forearmed when it comes to the interpretation of ERPT
results, but the message is stronger: policy-makers should insist on the misspecifications discussed
above being addressed.

Acknowledgements
Janine Aron acknowledges support from the British Academy (British Academy Research
Development Award). This research was also supported in part by grants from the Open Society
Foundation and the Oxford Martin School. We are grateful to Gregory Farrell, Ekaterina Kortava and
an anonymous referee for helpful comments.

Notes
1. Emerging market and developing economies accounted for 40 per cent of world exports in 2011 compared with 21 per cent
on average in the 1990s (IMF Direction of Trade Statistics).
2. Menon comprehensively surveys and tabulates empirical studies on ERPT up the early 1990s; Goldberg and Knetter use a
unifying framework to examine some key contributions on the law of one price, purchasing power parity, ERPT, and
pricing-to-market, linking to the literature on industrial organization.
3. Exchange rate changes are not always the same as exogenous exchange rate shocks. With feedback effects, the pass-through
from exchange rate changes could be different from exchange rate shocks. This distinction is explained in this survey and
applied in Aron, Farrell, et al. (2014).
4. In the extreme case of PCP, the law of one price holds for all goods and purchasing power parity is satisfied in the aggregate
(assuming markets are not segmented).
5. Switching costs provide another mechanism of this type, where incomplete pass-through arises because firms attract
customers with lower prices in the current period, knowing that customers will remain attached to the firm in the future due
to high switching costs.
6. We assume here that marginal costs are constant for convenience of exposition.
Exchange Rate Pass-Through in Developing and Emerging Markets 139

7. A linear demand function and flexible functional forms for demand as used in some of the micro-literature (Section 7) will
generate variable mark-ups, unlike a constant elasticity demand function, where the mark-up is constant.
8. Mishkin (2009) compares two versions of the Federal Reserves SIGMA DSGE model. In one, DixitStiglitz constant
elasticity demand functions result in complete long-run ERPT; but in the other, the assumption that the elasticity of demand
increases as market share declines results in far lower levels of EPRT.
9. This combines a linear demand curve, constant marginal costs and homogeneous goods (perfect substitutability between
domestic and imported goods). The ERPT elasticity then depends on the relative market shares of domestic and foreign
firms.
10. The marginal cost curve here slopes upward; marginal costs fall as output contracts in response to an appreciation in the
exporters currency, so ERPT is incomplete.
11. Exporting firms building market share may squeeze mark-ups when the destination currency depreciates, to stabilise the
local price (Channel 1), but leave mark-ups intact when appreciation lowers prices for importers. At the extreme, there could
be full ERPT after appreciation and zero ERPT after depreciation.
12. If firms face capacity constraints and cannot satisfy increased demand at the lower price, at least in the short term, then not
all the appreciation would be passed through and local prices could rise (Knetter, 1994). After depreciation, downward price
or wage rigidities (Channel 3) could limit a decline in the price so the ERPT could exceed zero. Lowering prices is usually
more feasible than raising them, so a lower ERPT for depreciation than appreciation could arise again (Bussiere, 2007).
13. This issue is by no means settled even in advanced countries, see (Dale, 2011) on the underestimation of ERPT to import
prices in 2009 in the UK.
14. A regime shift with the opposite effect is trade liberalization; even with tariff reduction leading to more open trade regimes,
significant non-tariff barriers may remain which themselves limit ERPT (Menon, 1996).
15. A survey for Asia is by Ghosh and Rajan (2007).
16. Fendel, Frenkel, and Swonke (2008), surveying German exporters, contradicts both pure LCP and pure PCP hypotheses.
17. By contrast, the pricing method chosen by foreign firms in most models is regarded as exogenous to domestic monetary
policy (though see an exception in Devereux and Yetman [2010]).
18. The constant elasticity demand function, though widely used in the literature, has the implausible implication that demand
for a good only tends to zero when the price tends to infinity. For most traded goods, it seems more plausible that demand
would become zero at finite price thresholds given the availability of partial substitutes. This guarantees a falling mark-up as
that threshold is approached, for example through local currency depreciation, so resulting in incomplete ERPT.
19. The term super-elasticity (rate of change of the price elasticity of demand) has been used to describe how the mark-up
varies as the price changes (see Nakamura and Zerom [2010] for empirical evidence).
20. The constant, , is an average of industry-specific fixed effects (calculated when the log of the real exchange rate is zero).
For simplicity, the relationship between the mark-up and the real exchange rate is log linear, and implies that the mark-up
decreases (that is, the price elasticity of the underlying demand function increases) with the exporters price. A more general
formulation could allow a flexible, non-linear demand function (see Section 7).
21. A common simplifying assumption is that marginal cost is not affected by a change in the exchange rate. However, there
may also be costs (for example, from imported inputs) that fluctuate with the exporters own trade-weighted exchange rate.
22. Appreciation (a percentage rise) or depreciation (a percentage fall) in the exchange rate is expressed as a difference in the log
of the exchange rate: et logEt .
23. A non-stationary process can wander away from a constant or a linear trend without limit. An I(1) non-stationary process has
to be differenced to become stationary or mean-reverting over time. An I(2) process needs to be differenced twice. In a
random walk, a simple version of non-stationarity, the change in the exchange rate is equal to a random term, and its path
over time is the cumulation of successive random terms, so that the exchange rate is not predictable, an uncomfortable result.
24. This applies if the underlying series are non-stationary series integrated of order 1, or I(1). If they have higher orders of
integration, say I(2), they will have to be differenced again to achieve a stationary series. Some prices are thought to have I
(2) behaviour, though this can result from structural breaks in an I(1) process, so that inflation then behaves like an I(1)
variable.
25. The original Campa and Goldberg model is expressed in individual prices for industrial sub-sectors.
26. Not included were commodity prices, demand in the exporting country and destination country costs.
27. We define the exchange rate so that a rise is an appreciation, as above, which differs from the original Campa and Goldberg
(2005) paper. Hence the pass-through measures are designated with a negative sign.
28. If one lag of the dependent variable had been included as regressor, then would have to be to be divided by 1 minus the
coefficient on the lagged dependent variable to calculate long-run ERPT, but see online Appendix 1 for further discussion.
29. Long-run price homogeneity (see Section 3) entails that 1 2 3 1.
30. The Hodrick Prescott filter constructs a long-term trend over a sample, using the entire sample. Thus, current and later
information on the exchange rate (and hence destination country CPI) is incorporated in the trend used to explain the CPI,
implying an endogeneity bias.
31. With both an ecm term and (one or more) lags in the dependent variable, computation could be done by dynamic simulation
(see online Appendix 1).
32. Chow tests evaluate parameter stability based on exogenously imposed breakpoint, whereas other tests use endogenously
determined structural breakpoints (for example, Andrews, 1993). In both cases, the asymptotic tests entailed have limited
140 J. Aron et al.

statistical power in the data samples available for analysis. Rolling regressions can also be used to determine the location of
the breaks.
33. Several Canadian import prices are constructed by multiplying the foreign-currency price by the nominal exchange rate, so
that the degree of ERPT is, by construction, equal to 1 for those prices, biasing upwards the average empirical estimates of
ERPT (Bailliu & Bouakez, 2004).
34. Goldberg and Knetter (1997, p. 13) furthermore argue these proxies may introduce measurement error that is correlated with
exchange rates in a way that biases coefficients toward finding incomplete ERPT and excessive mark-ups, a problem that
becomes more acute with foreign outsourcing (that is, as the share of costs incurred in the home currency then declines).
35. Trade-weighted consumer prices are easily derived from real effective exchange rate indices, now more widely available for
emerging markets from the mid-1990s (for example, from the BIS and IMF).
36. The CPI in the EU has no owner-occupied housing, but in Australia and the United States it is included, for example.
37. It makes a big difference to ERPT estimates if oil or commodity prices are included to help control for costs (Bussire &
Peltonen, 2008). Hellerstein and others have objected to their inclusion for the United States where the NEER and oil prices
appear to be correlated. This is unlikely to be the case for most emerging market countries.
38. Advanced country benchmarks are given in Table 2.
39. In Brun-Aguerre et al. (2012), for South Africa, one country in the panel, the error was to convert an import price already in
rands (domestic currency) by multiplying it by the rand/dollar exchange rate. Details are available on request. This also
biases their estimates for the short run: ERPT after one quarter measures up to 160 per cent (models a,b,c, see Table 1) and
after five quarters at 250 per cent (model b).
40. Calvo and Reinharts set of advanced countries consists solely of Australia and New Zealand, giving a short-run average
ERPT rate of 7 per cent. This should be compared with Campa and Goldbergs short-run average for 25 OECD countries of
46 per cent (though for a longer sample).
41. Low, moderate and high inflation groups are defined by average inflation rates less than 10 per cent, between 10 and 30 per
cent and more than 30 per cent, respectively. However, note there is a classic selection bias because the division into
inflation groupings is done on the basis of the dependent variable (the inflation rate). Hence, group differences will be
somewhat exaggerated.
42. To facilitate comparison with single equation estimates, this study, like Bache (2007) and Ito and Sato (2008), divides the
cumulative impulse response function (IRF) for domestic prices by the cumulated IRF for the exchange rate.
43. The (pooled) Latin sample covers only 20002005, and, by avoiding the excesses of inflation of earlier years, shows lower
ERPT than the SSA sample.
44. For instance, Kohlscheen (2010) examines Spearman rank correlations between 6-month and 12-month ERPT coefficients
for eight countries, including inflation (average and median), inflation variance, NEER volatility, trade openness, food and
energy trade; and size (constant GDP). ERPT is mainly linked with the volatility of exchange rates and the composition of
trade.
45. In Table 1, Kohlscheen, Akofio-Sowah and Mihalek and Klau, could not find size effects. Bussire and Peltonen suggest
that outliers induce poor empirical findings on size effects (for example, Japan is a large economy with high ERPT).
46. The problem concerns the model used to analyse the time-varying ERPT elasticities from rolling window estimates. In this
rolling exercise, the window start-point varies from 1980Q1 to 1985Q1and the end-point varies from 2004Q3 to 2009Q3,
for the longest samples. The estimated ERPT elasticities will depend on information over the entire window used. Hence,
sensitivity of these ERPT elasticities will be as great to structural breaks in the early part of the sample (for example,
1980Q11985Q1) as in 2004Q32009Q3. It is therefore incorrect to explain the time and cross-section variation of the
ERPT elasticities with drivers dated only at the penultimate observation of each rolling window. The average information
over the entire window is required for these drivers.
47. This can generate spurious asymmetry findings which would not arise if heterogeneity had been allowed for.
48. In practice, de jure regimes may not coincide with the actual regime; for example, due to the fear of floating.
49. A peg is more vulnerable to rupture in its first year, but also more likely to endure the longer it has lasted, and if it breaks is
then likely to re-form more quickly.
50. Razafimahefa (2012) acknowledges that the findings need to be interpreted cautiously.
51. Kohlscheens correlations for eight countries floats between measured ERPT and average inflation and inflation volatility,
produce no clear pattern.
52. This confirms the findings of Mishkin and Schmidt-Hebbel (2007) for emerging market targeters.
53. Mihalek and Klau (2008) claim a fall in ERPT for most countries but this is unreliable (column 2 of Table 1).
54. The South African study of Aron, Farrell, et al. (2014) also uses interaction effects.
55. This bivariate VAR model lacks controls and may simply be picking up patterns in omitted variables.
56. Menon (1995, 1996) emphasises, however, that under perfect competition a tariff will not reduce ERPT whereas a quota
will. Quotas lower the ERPT for Australia.
57. For example, imports plus exports to GDP or the import share of GDP; see Aron and Muellbauer (2007) for a critique and an
alternative measure.
58. Akofio-Sowah also interacts the change in trade flows with et ; and finds it insignificant (unsurprisingly, as differencing
renders the variable stationary). Openness is not included separately.
59. The Standard International Trade Classification (SITC) and Harmonized System (HS) are different trade classifications,
enabling trade price comparisons amongst different countries and years, from the late 1980s. The UN-maintained SITC
Exchange Rate Pass-Through in Developing and Emerging Markets 141

categorises by the materials used in production/processing stage to five digits, while the HS allows disaggregation by
product up to at least six digits.
60. See Aron, Creamer, Muellbauer, and Rankin (2013) for a brief survey of these studies.
61. Aron and Muellbauer (2012) survey the international literature, also reporting results for South Africa.
62. However, see comment by Sato in Campa and Goldberg (2008).
63. The micro analyses for the beer and automobile industries use static equations; Nakamura and Zerom (2010) explore the
coffee market with a dynamic model. However, all these models, and hence the role attributed to mark-up, rely heavily on
the functional form assumptions employed for estimated demand.
64. Barhoumi (2006), alone in this literature, tests and soundly rejects this restriction of homogeneous ERPT across countries.

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