1 Exchange rate pass-through

From 2002 to today, US $ has depreciated by around 40% against basket of

major currencies (trade weighted): how much in ation does this imply for the
US (via increased import prices)?

Depends on how much of the falling value of US currency is passed through to

import prices and then to consumer prices.

Important consequences for in ation but also for the impact of monetary policy:
in Mundell Fleming, Dornbush model typical 100% pass-through is assumed (ex-
change rate changes a ect exports and real activity through expenditure switch-
ing). Argument of Friedman on flexible exchange rates
Debates on how exchange rate changes a ect adjustment of global imbalances
depend on how exchange rates a ect prices and quantities: if small e ect of
exchange rates on import prices, on consumer prices then small e ect on demand,
exports, and current account?

Link with question of modelling nominal rigidities in an open economy: are prices
rigid in the currency of the exporter or the importer?
Real exchange rate movements are large but small e ect on prices and quantities?

Part of the "disconnect puzzle"

1) incomplete pass-through of ER movements into import prices: Campa and

Golberg (2005), OECD: 50% after 1 quarter; 64% after 1 year

Even after conditioning on a price change (Gopitah and Rigobon, 2008): Trade
weighted ER pass-through into U.S. import prices is is 22%: Price rigidity not
the full answer

2) Exchange rate changes have little e ect on agregate quantities (exports):

Typical macro elasticities are around 1 or just above: much lower than elasticities
suggested in trade literature
 1) `Producer Currency Pricing' (PCP)

Exporters preset prices in their own currency (PF : price of of foreign good sold
in H , expressed in foreign currency) and let prices abroad (PF :price of of foreign
good sold in H , expressed in home currency) move one-to-one with the exchange
rate E (domestic currency per unit of foreign currency). Here Home is importer.

PF = EPF

There is one-to-one pass-through of exchange rate movements onto the price of

imports, at both the border and the consumer-price level. Hence, once measured
in the same currency, goods prices are identical in all markets: the law of one
price holds.
2)`Local currency pricing' (LCP)

Firms preset a price on the export markets that may be di erent from the price
on their domestic market. Hence `Local Currency Pricing', or LCP:PF is rigid
and di erent from EPF Exchange rate pass-through on import prices is zero at
both the border- and the consumer-price level. The law of one price is violated
anytime the exchange rate uctuates unexpectedly.

No e ect of exchange rates on consumer prices, demand and exports!

2 Exchange rate pass-through: evidence

Correlation between exchange rate movement and in ation not very strong:

Example UK 1993-1994 (ERM crisis): Pound depreciates by 15% but in ation

only 2%What happens to consumer prices of imported goods when exchange
rate depreciates?

Macro and micro evidence point to low pass-through

See Campa and Goldberg: import price of a country (for a speci c good) can
be written as a transformation of export price of foreign country (in foreign
currency):

P mj = EP xj

Export prices depend on a markup over marginal costs. In log terms (small
letters):

pmj = "+mkupxj +mcxj

The markup itself may depend on sectoral characteristics and may react to
exchange rate:
mkupxj = + "

The marginal costs of the exporter depend on exporter wages and destination
market conditions:

mcxj = y + wx

so:pmj = + (1 + )" + y + w x

Pass-through measured by: =1+

= 0 :producer currency pricing, 100% pass-through

= 1 :local currency pricing, 0 pass-through (exporters absorb exchange rate

movements in their markup and their producer prices)
Test:

Use quarterly data on import price indices (23 OECD countries): 1975-2003

To allow for gradual adjustment of import prices test in rst di erences:

X4 X4
mj j j j j j j j
pt = + i "t i + i wt i + i gdpt + ut
i=0 i=0

j
Short run (one quarter) elasticity: 0

X4
j
Long run (one year) elasticity: i
i=0

estimated with OLS

 elasticities of ER Pass-through into agg. import prices
short run long run
France .53 + .98
Germany .55 + .80
Italy .35 + .35+
Japan .43 + 1.13
Netherlands .79 + .84
UK .36 + .46 +
US .23 + .42 +
Average (23) .46 .64
*+ : elasticity 6= 0; 1 at 5% level

Note low US pass-through; LCP rejected in most countries in SR and LR; PCP
rejected also in SR but less in LR (7 out of 23 countries); Some evidence that
pass-through has fallen over time
Burstein et al. (2005)
Micro-evidence: Gopitah and Rigobin (2008) "Sticky borders"

Evidence of price stickiness at the US border: micro data on import and export
prices collected by the Bureau of Labor Statistics for the United States: 1994-
2005.

1) prices are sticky in the currency in which they are reported as priced.

Average price duration for market transactions = 10.6 months for imports and
12.8 months for exports (wholesale prices at the border)

Prices of manufactured goods much more sticky than primary products

2) Local currency pricing for U.S. imports and producer currency pricing for U.S.
exports

Close to 90% of U.S. imports and 97% of U.S. exports are priced in dollars.
So local currency pricing for imports and producer currency pricing for exports:
Asymmetry in terms of which country bears the risk of exchange rate movements.

3) trend decline in the probability of price adjustment for imports

The average probability of price change has declined by 10 percentage points

from 1994 to 2004. But not much coming from composition e ect (more trade
in di erentiated goods) as in Campa and Goldberg

4) exchange rate pass-through into U.S. imports even conditioning on a price

change is low.
Even conditioning on a price change, trade weighted exchange rate pass-through
into U.S. import prices is low, at 22%: estimate pass-through conditional on
an observed price change (6= standard lag speci cation used in aggregate re-
gressions). Measure pass-through as the change in prices in response to the
cumulative change in the exchange rate since it last changed its price.
Currency choice and exchange rate pass-through (Gopinath, Itskhoki and Rigobon,
2009)

- choice of currency of invoicing is endogenous

Estimate a standard pass-through equation; monthly aggregate data

Xn Xn X3
pk;t = i + j ek;t j + j k;t j + j yt j + k;t
j=0 j=0 j=0
What happens when one conditions on price change?
Good level estimations:
h i
p i;t = + N D (1 Di) 0
+ Zi;t + i;t
D Di c ei;t

p i;t : change in log dollar price conditional on price adjustment in the currency
of pricing

c ei;t :
cumulative change in the log of bilateral exchange rate over duration of
previous price

Di: dummy for price in dollar

even conditioning on price change, dollar pricers have lower pass-through: cur-
rency choice tells us something on long run desired pass-through whether it
comes from variable mark-ups or imported inputs
3 Pricing to Market: Theory

Main mechanism:

Pricing to market can be generated in any model where depreciation of exporter's

currency lowers the perceived elasticity of demand of exporters (not CES):

- Melitz Ottaviano (2008): linear demand functions; price elasticity of demand

" with consumer price: depreciation means lower relative costs, lower consumer
price, lower demand elasticity: exporters react by increasing markup

- Atkeson and Burstein (2009): imperfect competition (Cournot). Depreciation

increases market share of exporters in destination market =) lower demand
elasticity
 pi
- Corsetti and Dedola (2007): local additive distribution costs. pci "i i + i wi ,
with depreciation ("i ") a smaller share of nal consumer price depends on
exporter price, lowers elasticity of demand =) increase markup

Same mechanism for rms productivity: higher productivity rms have lower
demand elasticity to start with ) higher prod. rms do more pricing to market
(absorb more exchange rate movements in their markups)

Key mechanism in these papers: a depreciation lowers the price elasticity of

demand so mark-up increases with depreciation: exporters react to a depreciation
by increasing their price in domestic currency and do not pass-through entirely
the depreciation to foreign consumers
 Theory with distribution costs

Simple model: Home rms export to N countries, one sector (manufacturing)

with monopolistic competition

standard Dixit-Stiglitz utility:

2 3 1
Z 1 1=
6 7
U (Ci) = 4 x(')1 1= d'5 x('): consumption of variety '
X

': productivity of the rm; >1

 Transaction costs

- iceberg trade cost i > 1 speci c to the pair (Home; country i)

- xed cost to export: Fi

- distribution cost: Tirole (1995) "production and retailing are complements".

pi (')
Consumer price (in currency i): pci(') "i i + i wi

Distribution costs iwi: any additive cost paid in local currency that does not
depend on rm productivity '

"i: nominal exchange rate between Home and i (" "i = depreciation vis a vis
currency i ) ; pi('): producer price to destination i in Home currency; wi:
wage rate in i currency
 Demand

h i
pi (')
Demand for a variety: xi(') = YiPi pci(') = YiPi "i i + iwi

Yi income; Pi price index in i.

 Optimal prices

Producer price pi(') in Home currency of variety ' sold in country i:

!
i qi ' w
pi (') = 1+ '
1 i }
| {z
mi (')

"i wi
Real exchange rate qi w

Mark-up mi(') increases with depreciation and with productivity

Perceived demand elasticity for producer falls with depreciation and productivity

i + i qi '
i (') =
i + i qi '
<
The impact of a (real) depreciation on the producer price (in domestic currency):

dpi (') qi i 'qi

= 'qi > 0 : Endogenous and heterogenous pricing to market
dqi pi (') i+

Testable Prediction 1.The elasticity of the producer price, pi(') to an increase

in qi is positive and

i) increases with the productivity of the rm ' (and more generally export per-
formance)

ii) increases with local distribution costs i

Intuition: perceived distribution costs weaken the demand elasticity the more
so the lower production costs (the higher the exchange rate and the higher the
productivity)
Import price and consumer price (in currency i):

pi (') i wi wi
pm
i (') = "i = i
1 'qi + i ; pci (') = i
1 'qi + i

Incomplete pass-through of a depreciation for import and consumer prices i

dpm
i (') i qi i dpci (') qi i
pm
= ; dqi pci (') =
dqi i (') i+ i qi ' i+ i qi '

Two mechanisms: local distribution costs + mark-up increases

 Quantities

h i
1 i 1
xi(') = YiPi 'qi wi + iwi

ideal price index in country i depends on all bilateral RER of i:

! 1=( 1)
PN R1 1
wi
Pi = h=1 Lh 'hi 1 i + 'qhi dG(')
hi

E ective RER appreciation of i , # Pi ) # exports from Home.

Home is too small for its bilateral RER to a ect Pi.

The impact of a change in bilateral RER on the volume of exports:

dxi (') qi i
dqi xi (') = + <
i i qi '

Testable Prediction 2. The elasticity of the rm exports, xi(') to a real depre-

ciation (an increase in qi) is positive and

i) decreases with the productivity of the rm

ii) decreases with the importance of local distribution costs

Intuition follows from endogenous pricing to market

 Pro ts and the extensive margin

Pro ts for an exporter to i increase with depreciation:

1 h i1
Yi i 1 i qi qi
i (') = 1 Pi ' +
i wi w Fi

Threshold prdoductivity of the "zero pro t" rm 'i exporting in i:

Only high productivity rms can export: (those that price to market)

d'
Threshold productivity # with depreciation: dq i 'qi = 1
i i

Entry of less productive and smaller rms triggered by a depreciation

 Empirics

Data: Large database on French rms. 2 sources:

1) French customs for rm-level trade data: export, for each rm, by destination-
year, both in value and volume;

2) Firm-level information from INSEE: sales, employment, sector...

Merge the two: virtually all individual French exporters still present (90%)

Period: 1995 to 2005

 Export unit values.

Producer prices (proxied by export unit values): pi (') = i qi ' w

1 1+ i '
depend on

1) i, i: rm-destination xed e ects 2) w: year dummies 3) qi =

wi"i=w : real exchange rate 4) ': lagged rm labor productivity

Log (U nithit) = 1Log ('ht 1) + 2Log (RERit) + t + hi + hit

RERit:average RER between France and i during year t.

Also allow delayed e ect on producer prices

Testable implication 1: 2 larger for high performance rms

 Aggregate exports

Pareto distribution for productivity: G(') = 1 ' k , k inverse measure of

productivity heterogeneity. G(')

Elasticity of aggregate exports to RER = intensive + extensive elasticities:

Z1
@Xi qi qi @xi(') qi @'i
@qi Xi = X L dG(') Lxi('i )G0('i ) =k
i @qi X
| i {z
@qi}
'i
| {z } extensive > k
intensive <