1020 7635 Article A002 en

The Effect of Exchange Rate
Changes on the Prices and Volume

of Foreign Trade
MORDECHAI E, KREININ *
I. Problem and Conceptual Framework

1. STATEMENT OF THE PROBLEM
W ITHIN THE TRADITION of the elasticity approach to the balance of

payments,1 exchange rate adjustment falls into the general category
of switching policies (in the "old" Johnson sense). Along with tariff
changes and a variety of other measures, exchange variations are
expected to change the relative prices of importables and exportables, and
thereby induce shifts in production and consumption mixes. These
changes, in turn, are expected to restore or to maintain equilibrium in the
balance of payments. But the expected salutary effects of exchange rate
adjustments can occur only if they are fully or partially reflected in the
prices of traded goods, rather than being offset by proportional changes
in domestic prices. The extent to which exchange rate changes are trans-
formed into changes in the prices of imports (denominated in the local
currency) and exports (denominated in foreign currencies) is known as
the "pass-through" effect of the exchange adjustment. Although the
* Mr. Kreinin is a professor of economics at Michigan State University. He

received his doctorate from the University of Michigan, where he also worked
at the Survey Research Center. He has served as a consultant to numerous
national and international agencies, and has been a visiting professor at several
universities.
Most of the work on this paper was done during the author's tenure as a
consultant to the Research Department of the Fund in the summer of 1976. The
U. S. component of the study was financed by a grant from the U. S. Treasury
Department.
1
The received theory of the balance of payments adjustment mechanism con-
sists of a succession of five approaches. See Harry G. Johnson, "Elasticity,
Absorption, Keynesian Multiplier, Keynesian Policy, and Monetary Approaches
to Devaluation Theory: A Simple Geometric Exposition," American Economic
Review, Vol. 66 (June 1976), pp. 448-52.
297
©International Monetary Fund. Not for Redistribution

298 INTERNATIONAL MONETARY FUND STAFF PAPERS
"monetary" approach (which centers attention on long-run equilibrium

and focuses on the demand for, and the supply of, money as a stock)
denies that devaluation can have a lasting effect on the balance of pay-
ments, even this approach admits to a transitory change in the terms of
trade occurring over the short run (without, however, specifying how
short the short run is).
This paper is devoted to an empirical estimation of pass-through
effects, and is limited to a time horizon of three to four years (i.e., the
relatively short run). Consequently, this paper belongs in the tradition of
the elasticity approach. In that context, the pass-through effect has
important implications, both for the balance of payments and for the
propagation of inflation. Specifically, the paper estimates the following:
(a) the pass-through effect of exchange rate changes of eight major cur-
rencies under the Smithsonian Agreement of 1971, with a partial investiga-
tion of the changes occurring in 1973; (b) the effect of the above price
changes on the volume of trade flows and the implied import-demand
elasticities; and (c) the elasticity of substitution in each of several major
countries as between third country suppliers over two time periods:
1970-72 and 1970-73.
2. SOME A PRIORI REASONING
In theoretical, partial equilibrium terms, the pass-through effect

depends on the elasticities of export supply and import demand of the
country and its trading partners. Although these elasticities are known to
vary between countries and over time,2 a few generalizations concerning
the pass-through effect can be made on a priori grounds. A small coun-
try, which can be assumed to face an infinitely (or very highly) elastic
supply of exports from its trading partners, is likely to experience a
nearly complete pass-through on the import side. In turn, only a partial
pass-through can be expected with respect to the import prices of a
large country, which presumably faces upward-sloping export supply
2
See, for example, the following studies: Morris Goldstein and Mohsin S.
Khan, "Large Versus Small Price Changes and the Demand for Imports," Staff
Papers, Vol. 23 (March 1976), pp. 200-25; Hendrik S. Houthakker and Stephen
P. Magee, "Income and Price Elasticities in World Trade," Review of Economics
and Statistics, Vol. 51 (May 1969), pp. 111-25; Mordechai E. Kreinin, "Disag-
gregated Import Demand Functions—Further Results," Southern Economic Jour-
nal, Vol. 40 (July 1973), pp. 19-25, and "Price Elasticities in International Trade,"
Review of Economics and Statistics, Vol. 49 (November 1967), pp. 510-16; and
James E. Price and James B. Thornblade, "U. S. Import Demand Functions
Disaggregated by Country and Commodity," Southern Economic Journal, Vol. 39
(July 1972), pp. 46-57.

EFFECT OF EXCHANGE RATE CHANGES ON TRADE 299
curves. In other words, such a country can, by its own actions, affect its
terms of trade. The reverse may be the case with respect to the supply
of exports. Here, a large country is likely to have a more elastic export
supply than a small one (because exports constitute a smaller proportion
of output in most industries in large countries) and is, therefore, less
likely to change export prices denominated in its own currency following
an exchange adjustment. Consequently, exporters in a large country are
likely to pass through a greater proportion of a devaluation or revalua-
tion than exporters in a small country.3
But this argument assumes that the small country specializes in the
export of a few commodities and that it exports a substantial portion of
domestic output of each commodity—an assumption that may be incor-
rect. Viewed from the demand side, the foregoing observations reflect
the fact that a small country is a price taker on the international market,
unable to influence its terms of trade. But this statement leaves open the
question of how large a country has to be before it acquires some control
over its terms of trade, as well as the different degrees of market power
associated with varying economic size. Consequently, the above a priori
statement must be regarded as tentative. In essence, the pass-through
question is an empirical one; it can be handled either through precise
knowledge of the elasticities involved, or by a method specifically
designed to measure the pass-through.
In many empirical studies of the domestic impact of commercial policy
conducted in the 1950s and early 1960s, there was a tendency on the
part of researchers to assume (implicitly or explicitly) a 100 per cent
pass-through. More specifically, it was commonly assumed that changes
in, say, tariffs were fully reflected in changes in import and/or export
prices. In recent years, the pendulum has swung almost completely in
the opposite direction (especially in some theoretical discussions). For
example, in the view of some economists the law of one price ensures
the same price on the world market for each internationally traded good
(including "differentiated" products). Consequently, given sufficient time,
exchange rate adjustments would be fully compensated for by changes in
domestic prices.
Furthermore, during the recent period of fluctuating exchange rates,
the issue has become a key factor in a certain theory that purports to
explain world-wide inflation. While the basic hypothesis involved, the
3
Note, however, that even if domestic export prices rise in full proportion to
the devaluation, there is an inducement to expand exports, since domestic output
expands and consumption contracts with the increase in local currency prices.

Mimdelí-Laffer (M-L) hypothesis, was developed by (or is attributed to)

Professors Robert A. Mundell and Arthur B. Laffer,4 who are also closely
associated with the monetarist approach, the M-L hypothesis is not an
essential ingredient of that approach. Mundell and Laffer assert that not
only do exchange fluctuations fail to equilibrate the balance of payments
but they also contribute to worldwide inflation. The argument runs roughly
as follows: The law of one price guarantees that, given sufficient time
for adjustment (and abstracting from transport costs), all internationally
traded goods will command the same price everywhere; this applies to
homogeneous and differentiated products alike. Thus, a currency devalua-
tion cannot, over time, change a country's prices relative to those of its
competitors; either its prices would rise or foreign prices would decline
until prices were fully equalized internationally. Here, Mundell and
Laffer introduce a second supposition—namely that the price response to
exchange rate adjustment is not symmetrical. Export prices (denominated
in local currency) rise in the devaluing country, but import prices fail to
decline in the revaluing one. This asymmetry is often referred to as the
"ratchet effect". As a consequence, the equalization of international prices
is accomplished strictly through price increases in the devaluing country.
Since, in a regime of fluctuating exchange rates, some currencies depre-
ciate and others appreciate over one time period, while the reverse tends
to occur during some subsequent period, and because domestic price
changes (i.e., increases) occur only in the depreciating countries and not
in the appreciating ones, the net effect is a world-wide increase in the
prices of traded goods.5
Both links in the M-L argument can be questioned. First, there is no
a priori reason for the law of one price to hold in the case of differen-
tiated products. Even a brand name can account for a persistent price
differential. The elasticity of substitution between different suppliers of a
4
See Mordechai E, Kreinin, International Economics: A Policy Approach
(New York, Second Edition, 1975), pp. 124-25; Arthur B. Laffer, "Do Devalu-
ations Really Help Trade?" Wall Street Journal (February 5, 1973), p. 10, and
"The Bitter Fruits of Devaluation," Wall Street Journal (January 10, 1974), p. 14;
Jude Wanniski, "The Case for Fixed Exchange Rates," Wall Street Journal (June
14, 1974), p. 10, and "The Mundell-Laffer Hypothesis—A New View of the
World Economy," Public Interest, Number 39 (Spring 1975), pp. 31-52.
For a more general discussion, see Marina ν. Ν. Whitman, "Global Monetarism
and the Monetary Approach to the Balance of Payments," Brookings Papers on
Economic
5
Activity (1975:3), pp. 491-536.
A further link in the inflation-propagating process—the effect of import pnces
on domestic prices—has been examined in Morris Goldstein's "Downward Price
Inflexibility, Ratchet Effects, and the Inflationary Impact of Import Price
Changes" (unpublished, International Monetary Fund, April 20, 1977). He finds
that, while import prices do affect domestic prices, there is no clear-cut evidence
that the effect is one-sided—that is, that it works only for price increases and
not for price decreases.

manufactured product having similar characteristics is less than infinite,

even in the long run/5 And, in any case, it makes a considerable differ-
ence whether the period required for price equalization following a cur-
rency devaluation is long or short. If it is very protracted (as implied in
some versions of the M-L hypothesis), then the argument that devalua-
tion does not improve a country's competitive position holds only in the
long run. Apart from the question of how long the long run is, it is
clear that improvement could occur, and persist, during the years in
which the price equalization process takes place. And that may be suffi-
cient for exchange rate adjustments to perform their traditional func-
tion of improving the country's competitive position and its balance of
payments.7 By the time the relevant period was over, other exchange rate
changes would undoubtedly occur.
Second, there is no a priori reason to expect a ratchet effect in the
case of exchange rate changes. Even if internal prices are inflexible in
a downward direction, import prices (expressed in terms of the home
currency of a revaluing country) can decline following an upward adjust-
ment in the exchange rate. Indeed, empirical studies have shown many
instances of such price reductions, on both a quarterly and an annual
basis, in the postwar period.8
In sum, the pass-through effect of exchange rate adjustment has
important implications, both for the balance of payments and for the
propagation of inflation. But its extent is an empirical question and can-
not be determined by a priori considerations. Such an empirical deter-
mination is the main purpose of the present study. Since this is essen-
tially a short-run investigation, it does not settle the theoretical issues
raised above. Nevertheless, it does shed light on the strength of these
factors over a three-year period.
Since the data available for this investigation are annual and not
6
For a casual observation of this phenomenon, the reader is invited to consult
"Compact Wagons: Volvo, Volare, Peugeot, Toyota," Consumer Reports, Vol. 41
(July 1976), pp. 384-91. Cars that are essentially similar in all characteristics
(i.e., Dodge Aspen and Volvo station wagons) exhibit very large and persistent
price differentials. In large measure, these differentials are caused by exchange
rate
7
changes.
See the review of The Monetary Approach to the Balance of Payments, ed.
by Jacob A. Frenkel and Harry G. Johnson (University of Toronto Press, 1976)
(hereinafter this book is referred to as The Monetary Approach) by Gottfried
Haberler in the Journal of Economic Literature, Vol. 14 {December 1976),
pp.8 1324-28.
See C. Pigott, R. Sweeney, and T. Willett, "Some Aspects of the Behavior
and Effects of Flexible Exchange Rates" (especially Table 10), U.S. Treasury
Discussion Paper (mimeographed, June 1975), and P. Isard, "How Far Can We
Push the Law of the One-Price?" Federal Reserve Board, International Finance
Discussion Paper No. 84 (May 1976).

quarterly, no time lags were built into the study—that is, it does not
investigate the lag of price movements behind exchange rate variations
or the lag of quantity changes behind prices changes. On the other hand,
because percentage changes in both quantity and price were generated,
their ratios would yield an elasticity of substitution between suppliers in
each of the countries being studied.
3. METHODOLOGY—A GENERAL DISCUSSION
While other students of the subject have employed econometric

models9 to examine the question at hand, this study relies on a "control
country" approach designed specifically for this purpose. In a sense, this
approach fulfills the role of a laboratory experiment or an economic
model in "holding other things constant." For, in any given year, a mul-
titude of factors affect the import and export prices of a country. Yet, in
estimating the pass-through effect, it is necesary to isolate the impact of
exchange rate changes on the prices of traded goods (as well as on the
volume of trade). In other words, the pass-through effect is the difference
between the change in prices that actually has taken place and the hypo-
thetical change that would have occurred in the absence of exchange rate
changes (but with all other influences allowed to have their full impact).
The problem is to obtain the hypothetical change. The approach
employed here uses a control country (or countries) to arrive at that
change. Ideally, such a country should be similar in all or most respects
to the country with which the control country is being compared, except
that its exchange rate did not change. Because such an ideal is rarely,
if ever, found in practice, we shall use several (usually three or four)
control countries for each country under study. (Additionally, we shall
examine the ñEture^of possible biases and develop alternative formulas to
deal with them.) In each case, the hypothetical price changes in the
investigated country are inferred from the average change that actually
occurred in the control countries. The control country (countries) vary
9
Consult, for example, S.Y. Kwack, "Price Linkages in an Interdependent
World Economy: Price Responses to Exchange Rate and Activity Changes,"
Federal Reserve Board, International Finance Discussion Paper No. 50 (Janu-
ary 3, 1975); Stephen P. Magee, "Currency Contracts, Pass-through and Devalua-
tion," Brookings Papers on Economic Activity (1973:1), pp. 300-25; Peter Clark,
"The Effect of Exchange Rate Changes on the U.S. Trade Balance," Federal
Reserve Board, International Finance Discussion Paper No. 52 (September 9, 1974)
(hereinafter referred to as Clark, "Effect of Exchange Rate Changes").
Also, see The international Linkage of National Economic Models, ed. by
Robert J. Ball (Amsterdam, 1973), and The Models of Project LINK, ed. by
Jean L. Waelbroeck (Amsterdam, 1976).

from one investigated country to another. They are selected in each case
so as to best hold "other things" (i.e., variables other than the exchange
rate changes) constant, and to isolate the effect of exchange rate changes.
A detailed description of the estimating procedures is offered in the
next section.
It is not claimed that the control country approach is better (or, for
that matter, worse) than alternative methods used to investigate the same
problem; only that it is different. When an issue is sufficiently important,
then—given the well-known possibility of errors in any empirical investi-
gation—it is desirable to employ as many approaches as possible to
investigate it. Similar results yielded by diverse methods would add con-
fidence to the estimates.
Although the control country (or, alternatively, a control product group)
approach is not often used in international economics, it has been
employed on several occasions, and by now has acquired a respectable
tradition in the field. Its use was originally stimulated by Orcutt's seminal
article on elasticity measurement,10 in which he demonstrated the strong
downward bias imparted by the traditional regression model and urged
the use of alternative methods. Since that time the control country or
control group approach has been employed to deal with such problems
as the effect of tariff changes on trade flows; trade and colonialism; the
effect of tariff concessions on the exports of developing countries; and
the effect of regional economic integration on the volume of imports.11
In all these cases the control country approach yielded fruitful results.
It has certainly proved robust enough to warrant its application to the
present problem.
10
Guy H. Orcutt, "Measurement of Price Elasticities in International Trade,"
Review of Economics and Statistics, Vol. 32 (May 1950), pp. 117-32, reprinted
in Readings in International Economics, ed. by Richard E. Caves and Harry G.
Johnson
11
(Hpmewood, Illinois, 1968), pp. 528-52.
Following are examples of studies which used this estimation technique:
J. M. Finger, "GATT Tariff Concessions and the Exports of Developing Coun-
tries—United States Concessions at the Dillon Round," Economic Journal, Vol. 84
(September 1974), pp. 566-75, and "Effects of the Kennedy Round Tariff Con-
cessions on the Exports of Developing Countries," Economic Journal, Vol. 86
(March 1976), pp. 87-95; E. Kleiman, "Trade and the Decline of Colonial-
ism," Economic Journal, Vol. 86 (September 1976), pp. 459-80; Lawrence B.
Krause, "United States Imports and the Tariff," American Economic Review,
Papers and Proceedings, Vol. 49 (May 1959), pp. 542-51; Mordechai E. Kreinin,
"Effect of Tariff Changes on the Prices and Volume of Imports," American
Economic Review, Vol. 51 (June 1961), pp. 310-24 (hereinafter referred to as
Kreinin, "Effect of Tariff Changes"), and "Effects of the EEC on Imports of
Manufactures," Economic Journal, Vol. 82 (September 1972), pp. 897-920, and
"A Further Note on the Elasticity of Substitution," Canadian Journal of Eco-
nomics, Vol. 6 (November 1973), pp. 606-608 (hereinafter referred to as Kreinin,
"A Further Note").

II. Approach and Estimation Formulas

1. THE USE OF CONTROL COUNTRIES
Under the 1971 Smithsonian Agreement, there was a realignment of

all major currencies. The exact change in the exchange rate of a given
currency depends on the weight assigned to each of that country's trad-
ing partners. Various indices have been constructed12 to estimate the
average changes in the exchange rate of each major currency. These
indices, which generally employ 1970 as a base period, were developed
for use in the period of fluctuating exchange rates. They differ from each
other in the nature of the weights assigned to each bilateral change in
the particular currency's exchange value.13 Regardless of the weighting
scheme, the indices show the following (approximate) exchange rate
changes of major currencies between 1970 and 1972: U. S. dollar
-10 per cent; Japanese yen +15 per cent; deutsche mark 4-6 per cent;
and French franc unchanged. Similar averages are available for other
currencies of the industrial countries. Most empirical investigations of
the effects of exchange rate changes utilize these average changes.
In contrast, the present study makes use of the fact that the average
change in the value of each currency is made up of differential degrees of
bilateral changes vis-a-vis different individual currencies. For example,
various currencies were revalued by different amounts relative to the
U.S. dollar in the Smithsonian Agreement of 1971. The Smithsonian
changes approximated the changes in exchange rates that took place
between (average) 1970 and (average) 1972. But because other adjustments
have occurred in the value of some currencies, the two sets of changes
are not identical. Table 1 shows the average 1972 exchange rate changes,
relative to the dollar, of 15 main countries of the Organization for Eco-
nomic Cooperation and Development (OECD). For the sake of con-
sistency with subsequent computations, mean dollar exchange rates in 1970
and 1972 were used as a base in computing the
(percentage) exchange rate variations.
Our interest lies in estimating the pass-through effects of these
exchange rate changes. In order to illustrate the method employed, we
*2See Rudolf R. Rhomberg, "Indices of Effective Exchange Rates," Staff

Papers,
13
Vol. 23 (March 1976), pp. 88-112.
The main types of weights used are bilateral trade (imports, exports, or an
average of the two) weights, global export weights, and weights derived from a
special Fund model (known as the multilateral exchange rate model, or MERM)
that are designed specifically to measure the effect of exchange rate changes on
the country's balance of trade.

TABLE 1. SIXTEEN OECD COUNTRIES: PERCENTAGE CHANGES IN U.S. DOLLAR

EXCHANGE RATES, 1970-72, AND INDICES OF INDUSTRIAL PRODUCTION AND OF
CONSUMER PRICES, 1972
Percentage 1972 1972

Change in Index of Consumer
U.S. Dollar Industrial Price
Exchange Rate Production Index
Country (1970-72) (1970-100) (1970 = 100)
Australia 7 108 112
Austria 11 114 111
Belgium 12 109 110
Canada 5 113 108
Denmark 8 111 112
Finland 1 114 114
France 9 112 112
Germany, Fed. Rep. 13 106 111
Italy 7 104 111
Japan 17 110 111
Netherlands 12 111 116
Norway 8 110 114
Sweden 9 104 109
Switzerland 12 104 114
United Kingdom 4 102 117
United States — 108 108
Sources: Exchange rate changes were calculated from the Federal Reserve Bulletin,
Vol. 59 (January 1973), p. A93. Consumer price indices were taken from Organization
for Economic Cooperation and Development (OECD), Main Economic Indicators
(August 1975). Indices of industrial production were taken from United Nations,
Monthly Bulletin of Statistics, Vol. 30 (April 1976), Table 10, pp. 22-33.
begin by using the United States as an example; that is, we ask what
effect did the dollar devaluation of 1971 have on the prices (and quan-
tities) of U. S. imports and exports? Each of the 15 main OECD coun-
tries revalued its currency relative to the dollar between 1970 and 1972.
Corresponding to each exchange rate adjustment, there was a change in
the dollar prices of U. S. imports from, and the foreign currency prices of
U. S. exports to, the partner country in question. But the observed
(bilateral) price changes cannot be fully attributed to the revaluations.
Caused by general inflation, differential monopoly power, and other fac-
tors, they would have occurred—at least in part—even in the absence
of the exchange adjustments. To isolate the effect of the dollar devalua-
tion on foreign trade prices, one must estimate the hypothetical price
change that would have occurred anyway. The difference between the
hypothetical and the actual price change is the effect of the exchange
adjustment on foreign trade prices.
The control country approach is used to estimate the hypothetical
price change for each revaluing country. Assume, for example, that
Finland and Norway are identical countries in all respects (including the
bundle of goods they export to the United States), except that Norway

revalued by 8 per cent relative to the dollar between 1970 and 1972,
while Finland did not change its dollar exchange rate. If the U.S.
(dollar-denominated) import price index from Norway increased 16 per
cent, while that from Finland increased 14 per cent, the effect of Nor-
way's revaluation on its dollar export prices to the United States is taken
to be (16 per cent - 14 per cent =) 2 per cent, and its pass-through effect
on U. S. imports is then (2 - 8 =) 25 per cent. It other words, the export
price change of Finland (the control, or c, country) is used as a proxy for
the hypothetical price change of Norway (the / country in which follows)
in the absence of revaluation. Schematically (with all figures representing
percentages):
Estimated
Norway Finland Differential Pass-Through
+ 8 0 8
25
+16 +14 2
where ER$ is the percentage change in the dollar exchange rate between
1970 and 1972, and Ρ^-8· is the percentage change in U.S. import prices
from each country over the same period. In the general notations that
follow, the country under investigation (the United States in our example)
will be referred to as the Κ country. Estimates will be constructed for eight
such countries. In the study of each Κ country, there will be 3 to 5 c coun-
tries (the criteria used for their selection will be spelled out below), and 9
to 11 / countries (defined as all countries other than the c country selected
that trade with the Κ country), for a total of 33 to 45 observations. The
estimated pass-through of the Κ country is an average of these observa-
tions, with the averaging procedure to be described in Section II.5 below.
2. BASIC ESTIMATION FORMULA FOR BILATERAL IMPORT PASS-THROUGH
For greater generality, we introduce the following notation: {ERK and

K
CER are the 1970-72 percentage changes in the exchange rates of the /
and the c countries, respectively, relative to country K. These exchange
rates are defined as units of the Κ currency per unit of the / or c currency.
For example, if Κ is the United States, the expressions refer to dollar
exchange rates, defined as cents per unit of foreign currency. (In what
follows, we shall use the U.S. as an example of the Κ country whenever
an example is needed for the purpose of clear exposition.) CP%; ¿Pj£ are
the 1970-72 percentage changes in the prices of the Κ country's imports
from the c and the / countries, respectively (on products imported into
country Κ from both c and ι countries). Px and Pd refer to the 1970-72
percentage changes in export prices and domestic prices, respectively.

For any country Κ whose currency was devalued with respect to coun-
try /:
(1)
That is, the percentage change in the prices of country A^'s imports from
country / is a fraction «¿ of the percentage change in f s exchange rate
relative to K, where a{ is the measure of the pass-through. Considering
?ΡΜ as a proxy for what jPAI would have been in the absence of exchange
rate adjustment, the pass-through effect of the / country's revaluation is
estimated as:
(2)
In all calculations, the percentage changes of prices and exchange rates are
average 1970 to average 1972, with mean dollar exchange rates and mean
price levels in 1970 and 1972 used as bases; the commodity bundles in-
cluded in each comparison of the Κ country imports from the c and the
/ countries are those common to the two exporting countries, with the
matching done at as high a level of disaggregation as possible.
But this procedure assumes that the export prices in the control country
are unaffected by the revaluation of the Κ country's currency. In fact, the
rise in f^ would generate at least some switch in the Κ country demand
from country / to the control country, and would therefore raise CP^.
Although this effect is unlikely to be large14 (especially over a relatively
short time span), it biases the estimate downward. The result of the calcu-
lation must, therefore, be regarded as a lower bound, with the actual pass-
through effect being somewhat higher. Such a bias is inherent in the con-
trol country, or the control group, approach.
Equation (2) is the basic estimating formula for the bilateral import
pass-through. For each Κ country there are 3 to 5 control countries and
9 to 11 / countries, yielding a total of 33 to 45 «» bilateral observations.
The import pass-through of Κ is the average of these observations; this
will be discussed in Section II.5. But, prior to that, the next section will
dwell on various biases in the formula and will offer adjustments, as
well as alternative formulas.
3. BIASES, ADJUSTMENTS, AND ALTERNATIVE FORMULAS
In essence, then, the control country represents developments that

affect the prices of the / country's exports to the Κ country in the absence
14
In Section IV.2, the substitution elasticities are estimated at between -0.5
and -1.8.

of revaluation. In addition to being an important trading partner of the Κ

country, the "ideal" control country (or countries) should fulfill two
conditions: its exchange rate relative to the Κ country should remain
unchanged; and it (they) should adequately represent economic condi-
tions in the / countries. In particular, the control country (countries)
should—on the average—experience the same rate of growth and of
domestic inflation as the ι countries over the period being considered.
It is not always possible to find control countries that meet these condi-
tions.
Starting with the first condition and using the United States as an
example oí a K country, it may be seen in Table 1 that each of the 15
countries revalued to some degree against the dollar. As a consequence,
it was necessary to select as control countries those that revalued least.
This led to the selection of Finland, Canada, and the United Kingdom.15
Each was used separately to estimate the pass-through of a revaluation
of each of the 12 other countries, yielding 36 «ι bilateral observations.
But the use (as a control) of a country that revalued against the dollar
requires the introduction of two alternative assumptions, with the results
establishing lower-bound and upper-bound estimates of the pass-through
effect.
Consider the following illustrative scheme with respect to the dollar
exchange rates:
Germany, Fed. Rep. United Kingdom

13 4
16 12
Under the first assumption, none of the United Kingdom's (export) price
increase was owing to revaluation of the pound; the entire 12 per cent
rise would have occurred anyway. The hypothetical increase in the Federal
Republic of Germany's export price in the absence of mark revaluation
is 12 per cent, and the pass-through is estimated at I per
cent. This is the estimate generated by equation (2). Presumably, the num-
ber subtracted from the German price increase is excessive, and the esti-
mate should be regarded as a lower bound. The closer the (dollar) ex-
change adjustment of the control country is to zero, the closer the lower-
bound estimate is to the true estimate. As a second alternative, assume
15
None of the three countries is "ideal." Thus, Finland's exports are highly
specialized, while the United Kingdom suffers from perennial domestic problems.
Therefore, only average results are presented. These were later verified using Italy
as a control country.

that the control country (the United Kingdom) experienced a 100 per cent
pass-through. Then only 8 (12 — 4) per cent of the U. K. price rise would
have occurred in the absence of a sterling revaluation. The German pass-
through is then estimated at 61 per cent. This i s a reasonable
able assumption to generate the upper-bound («».„) estimate
(3)
As the revaluation of the control country relative to the Κ country

approaches zero, the lower and upper bounds converge. Because of the
downward biasdnherent in the control country approach (discussed pre-
viously), the actual estimate is probably closer to the upper bound than
the lower bound.
While the selection of control countries is dictated mainly by the
stability of their exchange rates relative to the Κ country, the second
condition requires that "on the average" they be representative of the
/ countries with which they are to be compared. This is one reason for
selecting several (rather than one) control countries and averaging the
results. However, whenever there is a difference between the average
inflation rates of the c countries and the / countries,16 an adjustment is
deemed necessary.
Specifically, the change in the / country's export prices Px is a function
of the change in its exchange rate and the change in its domestic prices:
Since our interest centers on the effect of the exchange rate, we wish to
hold constant the impact of domestic inflation. But Pd may be different in
the control and the / country. To account for the difference, the price index
of Κ country imports from the control country was adjusted in each com-
parison (with an / country) by the difference between the two countries'
1972 domestic prive indices (1970= 100).
(4)
where Λ and cPd are the domestic price indices of the ι and Κ countries,
respectively. An ideal index for this purpose would be one that included
16
When the United States is the country being investigated {a K country), the
average 1972 consumer price index of the three control countries (the United
Kingdom, Finland, and Canada) was 113. This compares with an average of 111
for the 12 / countries, and of 112 for the 15 countries combined.

all potentially traded goods but excluded imports. However, since such
an index was not available, the consumer price index was employed.17
The assumptions underlying this adjustment are that domestic price
changes are fully reflected in the prices of export goods, and that the effect
of exchange adjustment is superimposed upon them. Although they are
somewhat unrealistic, the bias introduced by these assumptions is probably
rather small, for the following reasons: first, because the discrepancy
between domestic prices and export prices is likely to be similar in the two
countries; and second, because the differences between iPd and cPd (and,
therefore, the adjustments themselves) are usually small. In other words
the control countries were usually representative of the / countries with
respect to their domestic rates of inflation (as well as their growth rates).
Equation (4) was inserted appropriately into equations (2) and (3) to
generate estimates adjusted for differential inflation rates. But, in most
cases, these did not differ from the unadjusted figures.
4. ESTIMATION FORMULAS FOR BILATERAL EXPORT PASS-THROUGH
A symmetrical analysis was undertaken with respect to exports. Again,

using the United States as the Κ country in a schematic illustration, as-
sume that U. S. export prices (Ρχ·8·) of identical bundles of goods destined
for the control country and the i countries changed as follows from 1970
to 1972:
/ Country c Country
10 0
+ 12 +8
Following the previous reasoning, the 10 per cent revaluation in the i
country caused U. S. export prices to rise by (12 - 8 =) 4 per cent.
Thus, (4 ·*- 10 =) 40 per cent of the revaluation was absorbed by a
rise in U. S. dollar export prices, and the pass-through effect is esti-
mated at 60 per cent. More generally, the pass-through effect of the
i country's revaluation relative to the Κ country is estimated from the
following equation:
(5)
As in the case of imports, a downward bias is introduced into 0Ρξ because

17
Unfortunately, the consumer price index contains many nontraded goods
and services on the one hand, and imported commodities on the other. However,
an index of producers' prices of manufactured goods or an index of unit labor
costs in manufacturing (the latter index is of questionable reliability, and is also
one step removed from the price index) were available only for some countries.

of substitution in demand for Κ country products from the control

country to the / country. The resulting estimate must be regarded as a
lower bound.
When the control country experiences a revaluation relative to the Κ
country, equation (5) becomes the upper-bound estimate, while the lower-
bound estimate is given by:
(6)
As in the case of imports, a price adjustment was deemed necessary. For

the change in the prices of the / country's imports from the Κ country (or
in the prices of the Κ country's exports to the / country) is a function of
the change in the exchange rate, as well as of the domestic rate of inflation
in the / country. In employing the control country approach, we wish to
hold the second factor constant, so as to concentrate on the first. Con-
sequently, similar price adjustments were introduced into equations (5)
and (6) as in the case of imports; that is, the cPf was adjusted upward
by cPd - iPd.
5. AVERAGING OF BILATERAL a¿ OBSERVATIONS FOR EACH Κ COUNTRY
No restrictions are imposed on the individual comparisons; only aver-

age results of all bilateral / country observations for each Κ country are
relied upon in arriving at the estimated pass-through. In addition to
unweighted averages, a weighted average was calculated in two steps.
First, an unweighted mean of each <*¿ estimate (generated by the three
to five control countries) was computed for each of the / countries. These
were then averaged by assigning each / country a weight proportional to
the Κ country's imports from it (or export to it) in 1970 and 1972. We
have
for imports ( represents imports of K)K)
ΌΓ exports (XK represents exports of K)
Yet another method of averaging the individual ai observations is by

estimating a weighted regression of the form
where Ρ represents the differential percentage price change between the ι

and the control country (<P£ - J>*)9 ER is the percentage exchange rate
change of the / country relative to the Κ country, and where the exchange
rate change of the control country is zero. Each observation is weighted
by the shares of the ι countries and the control countries in the pair in the
imports of the country Κ under study. Thus, in Figure 1, plotting Ρ
against ER, the 45 degree line represents a 100 per cent import pass-
through (i.e., the change in import prices equals the change in the ex-
change rate) and the regression line shows deviations from this position.
Plugging the change in the effective exchange rate of the Κ currency18
into the estimated equation yields an estimate of the pass-through.
To illustrate this method, consider the resulting equation for Japan's
imports
Figure 1
18
A shortcoming of this method in the present context is that the effective
exchange rate index is computed for country Κ relative to all currencies—the
control currencies as well as the ι currencies—while the regression line is esti-
mated on the basis of the relation of country ICs currency to the (adjusted)
i country currencies only.

when ER = 15 per cent, Ρ = 11.63, and the pass-through is estimated

at (11.63 -5- 15 =) 77.5 per cent. Similarly, for the United States, this
method yielded an import pass-through of between 35 per cent (lower
bound) and 70 per cent (upper bound; and an export 19 pass-through of
100 per cent.
In most cases, the various methods of arriving at the estimate yielded
similar (though not identical) results. Consequently, after several alter-
native estimates are discussed for the United States, only one (best) esti-
mate will be presented for each of the other countries.
6. ESTIMATION OF TRADE VOLUME AND ELASTICITIES
With respect to the quantity Q of trade, the control country approach

suggests that the percentage change in the Κ country's imports from
(exports to) the control country (whose exchange rate relative to the Κ
country did not change) serves as a proxy for the percentage change in
the Κ country's imports from (exports to) the / country in the absence of
exchange rate adjustment. The estimated effects of an / country revalua-
tion on the Κ country's imports from, and exports to, the / country would
then be (respectively):
and (7)
(8)
These would then be aggregated over all ι countries using a weighted
average as indicated earlier for prices. However, because of expected
substitution between sources of Κ country imports (and between destina-
tions of its exports) caused by the exchange rate adjustments, such esti-
mates must be regarded as upper bounds.
Implied in the quantity and price figures are estimates of the import
demand elasticity for each Κ country and of the elasticity of world
demand for each Κ country's exports.
Finally, the data generated will be used to estimate the elasticity of
substitution between various OECD supply countries in each Κ country
market. In most cases, these data contain 30 to 40 paired source country
observations of percentage changes in import prices and quantities
between 1970 and 1972, and between 1970 and 1973. Each observation
pertains to a common bundle of goods exported by both countries in the
pair. A regression of quantity change on price change (cross section)—
19
On the export side, the result shows the proportion of devaluation (revalua-
tion) absorbed by domestic price change, which equals 100 per cent minus the
pass-through.

both in percentage terms—would yield an estimate of the elasticity of

substitution in each Κ country market. The specific form of the regres-
sion is:
for each pair of suppliers i and / (covering matched products), where b

is the estimated elasticity.
III. Data and Computational Procedures

1. PERIOD COVERED
All observations employed in this paper relate to percentage changes

between 1970 and 1972. These two years are well suited for this study's
purposes. The economies of all OECD countries were on a steady expan-
sion path, with the indices of industrial production (1970 = 100) of most
European countries and Japan in the 105-112 range in 1972. Domestic
prices of the OECD countries advanced at a roughly similar and rela-
tively moderate pace. With 1970 equal to 100, the consumer price
indices of most industrial countries were in the 108-113 range in 1972,
although greater variations were exhibited in their indices of unit labor
costs in manufacturing.20 For some of the countries these indices show a
quantum jump in 1973; in all countries, an even greater jump occurred
in 1974, the year of double digit world-wide inflation. This behavior is
also evident in the export and import price indices. The point of this
discussion is that in 1970-72, and to some (but a lesser) extent in
1970-73, the exchange rate adjustments were major developments, whose
effect was unlikely to be swamped by that of the other price changes. The
same can hardly be said of 1970-74. The 1970-72 comparison is there-
fore considered reliable.
2. DATA SOURCES
Because the study focuses on the behavior of unit value and quantity
(or volume21), it requires the use of a set of commodity trade statistics
20
Consumer price indices are available in the OECD, Main Economic Indi-
cators (various issues). For some countries, the wholesale price index and the
index of producers' prices of manufactured goods are given in the same publica-
tion. Indices of unit labor costs in manufacturing for ten countries were compiled
and supplied privately by the Bureau of Labor Statistics, U. S. Department
of 21Labor.
The words quantity and volume are used interchangeably in this study. Unit
value is value divided by volume; it is used as the only available (albeit imper-
fect) proxy for price.

that are as disaggregated as possible. Only high disaggregated products are

homogeneous enough for the quantity information to be meaningful. For
the United States (as the Κ country), this study draws on the U. S. Treas-
ury's Trade Statistics U.S.A. data tapes for 1970 and 1972. Based on the
seven-digit Schedule A (import) and Schedule Β (export) classifications,
they include value and volume data for individual products imported to,
and exported from, the United States by source country and destination
country, respectively. For all other countries, the somewhat more aggre-
gated (four-digit or five-digit Standard International Trade Classification
(SITC) of commodities) OECD trade data tapes were used as the primary
data source. To check on the comparability of the data, the pass-through
effect of U. S. imports was estimated twice in the same manner using
both sets of data. The results were, indeed, very similar: in the 35-65 per
cent range using the U. S. census data, and in the 40-70 per cent range
using the OECD data.
3. COMPUTATIONAL PROCEDURES
Unit values (value -*- volume) were calculated for every commodity
imported into (exported by) the Κ country from (to) each of the industrial
countries show in Table 1 except Australia (which was included only
when the United States was designated the Κ country) for the years
1970 and 1972. These countries account for most of world trade in manu-
factured products. Trade flows that contained no volume information (pri-
marily because even the five-digit or seven-digit product was too hetero-
geneous) were rejected—that is, not included in the study. Next, the
changes from 1970 to 1972 22 in (a) volume (or quantity) and (b) unit
value were computed for every trade flow. Each change was then con-
verted into a percentage change, using the average of 1970 and 1972 as a
base.23 All subsequent computations involving averaging and aggregation
relate strictly to these percentages. The objective was to obtain paired
source countries (for Κ country imports) and paired destination countries
(for Κ country exports) for comparisons of average percentage changes in
unit values and quantities that in each case covered only those products
that were exported by (or to) both countries in the pair. This made com-
parisons possible between each / country and each control country with a
22
23
Specifically, 1972 minus 1970, taking note of negative signs.
For any given trade flows, the quantity Q and unit value UV formulas are,
respectively:

commodity bundle common to both of them. The procedure is best

described by the use of one illustration—U. S. (the Κ country) imports
from the pair of source countries made up of Canada and the Federal
Republic of Germany.
All disaggregated U. S. imports from both countries in the pair were
matched by their seven-digit number. Commodities not imported from
both countries were excluded from the comparison. For the accepted
products (i.e., those imported into the United States from both source
countries in 1970 and 1972), an average percentage change in unit value
and volume was calculated over all commodities. In calculating the aver-
age for each country, the value of U. S. imports of that product (from the
country) in the two years combined was used as a weight:
Similar indices were calculated for Canada.24

A similar procedure was followed for each pair of source countries of
U. S. imports. However, the commodity coverage differed between pairs,
because in each case only products exported by both countries in the pair
were included. Paired comparisons of quantity and unit values were also
made for U. S. exports, with respect to the countries of destination. The
same procedure was followed with respect to the trade of each Κ coun-
try. However, for the United States (only), in addition to averages cover-
ing all commodities, averages pertaining to all manufactures (SITC 5-8),
and to certain groups of manufactures were calculated. It is to these aver-
age percentage changes that the formulas developed in Section II apply.
IV. Results
1. PASS-THROUGH EFFECT
Of the 15 countries for which indices of changes in price and quanti-

ties were computed, France, Denmark, Norway, and Sweden experienced
24 Negative changes in either quantity or unit value were taken into account.

either no change or only minor changes in their effective exchange rates

between 1970 and 1972. Since some of the remaining countries were
"used up" as control countries, estimates were prepared for eight indus-
trial countries—the six countries appearing in Tables 2 and 3, plus two
small countries discussed in the text. In selecting the countries to be
studied, an attempt was made to include countries of different sizes, in
terms of their gross national products and international trade volumes,
and consequently of varying degrees of monopoly power on the interna-
tional market. Table 3 presents several estimates for the United States
(in addition to a regression-generated result mentioned in Section II.6),
while Table 2 presents the "best" estimates for six countries. As can be
seen in the second column of Table 2, the control countries differ
for each country investigated. Generally speaking, the results display a
measure of consistency regardless of which combination of control coun-
tries (out of those listed in each case) is used. In order to avoid an
impression of undue precision, all pass-through estimates were rounded
to the nearest 5 per cent. With two exceptions (listed in footnote 3 of
Table 2), the estimates correspond well to theoretical expectations.
We start with the estimated pass-through in the United States that is
shown in Table 3 and in the first row of Table 2. While the estimates
vary, depending on the commodity coverage and on the weighing proce-
dure used in calculating the averages, the figures do impart a distinct
impression. For U. S. imports, the pass-through effect is between 30 and
55 per cent (somewhat less than that for imports of chemicals). Consid-
ering the downward bias imparted to these figures by the control country
estimating procedure, the actual estimate is probably close to (somewhat
less than) one half. Foreign exporters absorbed over one half of the dollar
devaluation by lowering their export prices. Thus, if the effective exchange
devaluation of the dollar was about 10 per cent,25 then U. S. import prices
increased by nearly 5 percentage points, while foreign export prices
declined by more than 5 percentage points.
This is a relatively short-run estimate, where the period of adjustment
allowed for is less than a year. The estimate is reasonably consistent with
earlier findings concerning the effect of U. S, tariff reductions,26 and used
a similar methodology. It suggests that, at least in the short-run, the U. S.
import demand curve is roughly similar in slope to the foreign export
supply curve facing the United States.
In the case of U. S. exports, the estimates leave an unmistakable impres-
sion (again, without attaching undue significance to any individual figure)
25
26
See Rhomberg, op. cit.
See Kreinin, "Effect of Tariff Changes" (cited in footnote 11).

318
TABLE 2. Six INDUSTRIAL COUNTRIES: ESTIMATED EFFECTS OF EXCHANGE RATE ADJUSTMENT ON TRADE IN ALL COMMODITIES, 1970-72
Value of
Trade With Percentage
Industrial Change in Percentage
Direction Countries Estimated Effective Change in Change in Implied
INTERNATIONAL MONETARY FUND STAFF PAPERS

Κ Control of (average for Pass- l Exchange Terms of Volume of Elasticity
Country Countries Trade 1970-72) Through Rate Trade Trade of Demand
Billion U. S.
dollars Per cent
United States Canada Imports 32 50
-10 -5
-10 -2.00
United Kingdom Exports 28 100 + 17 -1.00
Finland
Germany, Fed. Rep. Belgium, Nether- Imports 25 60
+6 +3 no
lands, Switzer- Exports 30 90
2
discernible
land, Austria effect
Japan
3
Germany, Fed. Rep. Imports 9 80 +9.75 + 15 -1.25
Belgium Exports 11 85 + 15 -14 -1.10
Switzerland
Canada United Kingdom Imports 14 90 + 13 -2.50
Italy Exports 16 60 +6 +3 -14 -2.30
Belgium Austria Imports 11 90 no
Netherlands Exports 12 75 +3 +2 discernible
Switzerland effect
Italy France, Denmark, Imports 11 100
-2 no
Norway, Sweden Exports 11 100
2 -2 discernible
effect
1
A pass-through on the import side is defined as the percentage of the devaluation (revaluation) translated into an increase (reduction)
in domestic prices. On the export side, it is defined as the percentage of the devaluation (revaluation) translated into a reduction (increase)
in 2foreign import prices from the country under study, or 100 per cent minus the percentage change in that country's domestic export prices.
Figure appears to be unduly high.
3
Volume and estimated elasticity of import demand are biased downward.

TABLE 3. UNITED STATES: ESTIMATED PERCENTAGE PASS-THROUGH OF DOLLAR

DEVALUATION FOR IMPORTS AND EXPORTS, 1970-72
Unweighted Weighted Selected Country 1
Mean Average Weighted Average
Price
Commodity Adjust- Lower Upper Lower Upper Lower Upper
Group ment bound bound bound bound bound bound
Imports
All commodities Yes 20 55 35 65 30 60
No 25 50 15 35
SITCs 5-8 2 Yes 20 50 30 55 30 55
No 30 55 0 25
SITC5 No 20 50
SITC7 No 25 55
Exports
All commodities Yes 70 100 85 110 80 100
No 95 125 90 115
SITCs 5-8 Yes 80 110 90 115 95 120
SITC5 No 85 105
SITC7 No 105 125
1
Uses the United Kingdom as control for the large / countries; Finland as control for
the small / countries; and Canada as control for the medium-sized f countries.
2
SITC denotes Standard International Trade Classification.
that the devaluation pass-through was complete or nearly so.27 In other

words, U. S. exporters failed to raise their dollar prices as a result of the
devaluation; foreign currency prices of U. S. exports declined in propor-
tion to the dollar devaluation. This estimate is consistent with an infinitely
elastic (or nearly so) U. S. export supply curve which could result, at least
in part, from the small share of exports in the total output of most
U. S. industries. In sum, it appears that, in the short run, the U. S.
commodity terms of trade deteriorated by about half the proportion of
dollar devaluation, or by roughly 5 per cent.
Besides the United States, the Federal Republic of Germany and (to a
lesser extent) Japan appear to be "price makers" on the buying side of the
international market, with pass-through effects on the import side of 60
27
The results for the United States were checked by rerunning the estimates
using Italy as a control country. The estimates so generated closely approximate
the results shown in Table 2.
Also, the U. S. estimates conform to the results obtained for the floating
exchange rate period, using a distributed lag model, in Clark, "Effect of Exchange
Rate Changes" (cited in footnote 9), and to the estimates derived by Jacques
R. Artus in his paper, "The Behavior of Export Prices for Manufactures," Staff
Papers, Vol. 21 (November 1974), pp. 583-604.

and 80 per cent for Germany and Japan, respectively.28 For the remaining
three countries in Table 2, the import pass-through rises to between 90
and 100 per cent. Not reported in the table are estimates for Austria and
Switzerland, each of which show 100 per cent import pass-through. These
results conform to theoretical expectations in terms of their absolute size;
they conform especially well in terms of the country ranking.
On the export side, the estimated pass-through ranges from 60-100
per cent. The export pass-through appears to be invariably on the high
side, meaning that export prices expressed in domestic currencies did not
change much. For the Federal Republic of Germany and Italy, the results
appear to be unduly high, and to contain a possible upward bias. The
estimates for Canada undoubtedly reflect the importance of the United
States as a trading partner of Canada, for they are nearly a mirror image
of the U. S. results.
By applying the pass-through estimates in Table 2 to the respective
changes in the effective exchange rates, we obtain the changes in the terms
of trade of each country owing to the exchange adjustment. The largest
positive impact occurred in Japan, while the largest negative effect took
place in the United States. In sum, within the three-year time span under
consideration, the estimates support the traditional view that (when the
product of the supply elasticities exceeds the product of the demand
elasticities) devaluation worsens a country's terms of trade, while revalu-
ation improves them.
These results cast doubt on the strength of the so-called ratchet effect.
Foreign exporters to the United States met the revaluation of their cur-
rencies by lowering their export prices by more than half the revaluation,
more than matching the increase in import prices in the devaluing country.
Conversely, exporters to the Federal Republic of Germany (and, to a
lesser extent, to Japan) raised their prices by only 40 per cent of the
German revaluation.
Similarly, U. S. export prices, expressed in foreign currencies, declined
roughly in proportion to the U. S. devaluation,29 while Japanese and
Canadian export prices rose proportionately less than their revaluations.
Nor is there support for the M-L argument that domestic price increases
would fully erode any competitive gain from devaluation, or that currency
devaluations constitute the main force propelling the worldwide inflation.
28
Highly tentative estimates for the United Kingdom yield results similar to
those
29
obtained for Japan.
For evidence that such declines can also lower domestic prices in the import-
ing countries, consult Goldstein, op. cit.

On that latter point, additional (though highly tentative) evidence can be

gleaned from the data. The general impression one receives is that
domestic price movements in the countries of destination influence the
pricing policies of foreign exporters.
Export prices of any exporting country tended to rise more, or decline
less, in countries of destination that were plagued by relatively high infla-
tion, than in countries with a relatively stable price level, where
local competition was presumably stift'er. This suggests that the interna-
tional transmission of inflation following exchange rate adjustments
depends on domestic inflationary pressures in the importing countries,
rather than the converse. However, it should be stressed that this is a
short-run analysis, whereas the thesis attributed to Mundell and Laffer
(as well as the monetary approach to the balance of payments) is said to
hold only in the long run.
2. TRADE VOLUME AND ELASTICITIES
A marked effect on the volume of trade was observed in three of the

six countries investigated. For Belgium and Italy, the small size of the
exchange adjustment may account for the absence of change in volume,
but for the Federal Republic of Germany, the explanation must be sought
elsewhere. In the remaining three countries, the results conformed to
theoretical expectations. For the United States, imports are estimated to
have decreased by 10 per cent and exports to have increased by 17 per
cent as a result of the devaluation. Given a 10 per cent dollar devaluation
and a 50 per cent pass-through on the import side, this yields a U. S.
import demand elasticity of (10 ·*· 5 =) 2.30 With a 100 per cent pass-
through on the export side, the estimated foreign elasticity of demand for
U. S. exports is 1.7. Similarly, the import demand elasticities are 1.25 and
2.5 for Japan and Canada, respectively, while the foreign demands for
their exports have elasticities of 1.1 and 2.3, respectively. Not shown in
the table are estimated elasticities of Austria's demand for imports of
— 0.9, arid of foreign demand for Austria's exports of —3.5. Finally, it
should be noted that the volume results for Japan, and therefore the
implied elasticity of demand, are strongly biased downward because the
control countries devalued by 4 to 5 per cent relative to the yen.
Most elasticities generated by exchange rate changes may be lower than
tariff elasticities, because traders may consider exchange rate changes
reversible in making their pricing decisions, while the General Agree-
30
For manufactured products (SITCs 5-8), the estimated elasticity is 4.

ment on Tariffs and Trade rules make tariff changes irreversible for the
most part. However, most volume changes shown here are of sufficient
magnitude to meet the Marshall-Lerner stability conditions.
Corresponding to the calculation of the average differential change
(1970-72) in unit values of each Κ country's imports from pairs of source
countries is a similar calculation of the differential percentage change in
the volume of imports from the same pair over the same period, including
an identical bundle of goods. Since changes in Κ country income and
domestic prices can be assumed to affect both source countries to the
same degree, the differential change in quantity is attributable to the
differential change in foreign prices.
For U. S. imports, the linear regression (of percentage change quantity
differentials on percentage change price differentials) fitted to the paired
observations is
where the figures in parenthesis represent /-statistics. The size of the price
2
coefficient and its level of significance (as well as the R and the D-W
coefficient) remain virtually unchanged if each observation is weighted by
the share of U. S. imports from all industrial countries.
The elasticity of substitution in the U. S. market for all commodities is
thus estimated to be —1.8. This result corresponds well to short-run
elasticity estimates arrived at by other methods, and falls considerably
31
short (are about half the size) of estimated long-run elasticities
obtained when a ten-year period of adjustment (of quantity to price) was
allowed for.
Table 4 presents estimates of substitution elasticities for several coun-
tries based on price and quantity changes between (a) 1970 and 1972
and (b) 1970 and 1973. For the United States (for period (a) only),
estimates are also provided for some first-digit SITC groups.
What is generally striking about the estimates is their relatively small
size. With the exception of the United States, practically all countries have
a substitution elasticity of one or less, even when the period allowed for
is three years (1970-73).
V. Direction of Causality
Throughout this study, it has been assumed that exchange rate changes
affect the prices of traded goods, and not the converse; this is a fairly
31
See Kreinin, "A Further Note" (cited in footnote 11).

TABLE 4. ELEVEN INDUSTRIAL COUNTRIES: ESTIMATED SUBSTITUTION

ELASTICITIES, 1970-72 AND 1970-73 1
Country Commodity Group 2 1970-72 1970-73

Canada All commodities -1.0 -0.5
Denmark " -1.1 -1.4
Finland " -0.8
France " -1.0 -0.4
Germany, Fed. Rep. " -0.5 -0.5
Italy " -1.2 -1.3
Japan " -0.8 -0.2
Netherlands " -0.4
Norway " -0.8
Sweden " -0.6
United States " -1.8 -0.8
" SITC5 -1.2
" SITC6 -0.5
" SITC7 -1.5
" SITC 8 -1.8
1
Empty cells indicate results that are either statistically insignificant or that have the
wrong
2
sign. The estimates for Belgium yielded an incorrect (positive) sign.
SITC denotes Standard International Trade Classification.
safe assumption for the period under review. While only a properly speci-
fied distributed lag model can provide a conclusive test of this proposition,
it was suggested long ago by Gustav Cassel that the causation runs from
exchange rates to prices in a period of fixed exchange rates, and from
prices to exchange rates in a period of freely fluctuating rates.32 The
evidence presented in this study, based on the Smithsonian Agreement,
was obtained in the context of discrete exchange adjustments in a regime
of fixed rates. Moreover, the price comparisons between the 1970 average
and the 1972 average, with most exchange variations occurring in August-
December 1971, introduce two sequential time lags, of roughly 13 and 11
months, respectively, between the exchange rate changes and the two price
bases being compared. These features strongly suggest (although they do
not guarantee) that the causal effect is from exchange rate changes to
price changes.
This conjecture is supported by the results pertaining to the United
States, a country which was at one extreme on the spectrum of exchange
variations (i.e., it experienced the largest effective devaluation). It is well
known that the U. S. competitive position on world markets deteriorated
greatly in the 1960s, especially in the second half of the decade, and it
32
See Harry G. Johnson and Jacob A. Frenkel, "Essential Concepts and His-
torical Origins," in The Monetary Approach (cited in footnote 7), p. 29.

was this deterioration that led to the dollar devaluations in the early 1970s.
If causation ran from prices to exchange rate adjustments, then export
prices denominated in dollars (a proxy for domestic prices) would have
been expected to move up (in a relative sense), leading to the devaluation
of the dollar. Instead, no export price movement accompanied the
exchange adjustment—that is, a 100 per cent pass-through effect was
observed on the export side. This is consistent with an exchange adjust-
ment to price change causality, when the export supply elasticities are
infinite or nearly so. A similar point can be made concerning the terms
of trade. The terms of trade of the United States deteriorated, and those
of the Federal Republic of Germany and Japan improved following the
exchange adjustments. Again, this suggests that it was exchange rates
that influenced price movements.
By March of 1973, the fixed exchange rate regime gave way to fluctu-
ating rates. The purchasing-power-parity theory of exchange rate determ-
ination postulates that variations in (some index of) domestic prices
determine exchange rate fluctuations. Since exchange rate changes also
affect the prices of traded goods, the direction of causality can run both
ways. Consequently, in a 1970-73 comparison of exchange rate variations
with price changes, the causal relation is probably mixed. Indeed, in
studies correlating price and exchange rate movements in the recent period
of floating exchange rates, no causal relation can be postulated. Certainly,
a strong departure from, or a complete reversal of, the results mentioned
in the previous paragraph would suggest a causal relation from prices to
exchange rates, at least in part. And a mixed causality is what the results
for 1970-73 strongly suggest.
Using the same technique, this paper investigates the pass-through
effect occurring between (average) 1970 and (average) 1973 in some of
the major industrial countries. It will be recalled that the fixed exchange
rate system broke down, and floating rates were introduced, in March
1973. But, in most cases, the float was managed—sometimes heavily—
by government intervention. For Japan, it is widely assumed that govern-
ment intervention was so intense as to practically preserve the fixed
exchange rate regime. Indeed, the Japanese pass-through results for
1970-73 confirm this, for they were similar to those for 1970-72: 60 per
cent on the import side and 75 per cent on the export side. With a 22
per cent effective revaluation of the yen, this implies a terms-of-trade
improvement of 8 per cent.33 While there was no discernible effect on
33
Yen import prices declined by (0.60 X 22 per cent =) approximately 13 per
cent and export prices declined by (0.25 X 22 per cent =) approximately 5 per
cent.

Japan's import volume, its exports are estimated (by the control country
method) to have declined by 23 per cent as a result of the revaluation,
yielding a demand elasticity for Japan's exports of -1.4.
In contrast, the 1970-73 results for the United States reflect a "prices
to exchange rate," or a mixed, causality. The effective dollar exchange
rate fell 15 per cent, with an estimated pass-through of 40 per cent on both
the import and the export sides. This implies a 3 per cent improvement34
in the U. S. terms of trade. The association of depreciation with improved
terms of trade (precisely the reverse of the 1970-72 condition) suggests
a "prices to exchange rate" causality. Mixed causality is suggested by the
results pertaining to other industrial countries.
APPENDIX
Degree of Trade Overlap Among Exporting

and Importing Countries
In developing and testing theories of the commodity composition of

trade, it is often useful to be able to observe which two countries supply
similar products to a third market, and which two countries import similar
products from a third source. This problem is unrelated to the subject
matter of this paper. But since this study required the matching up of the
commodity bundles exported and imported by pairs of countries, it gen-
erated (at an intermediate stage) data that shed light on the degree of
trade overlap that may prove useful to other researchers.
Tables 5 and 6 present such matrices for French exports and imports,
respectively. Similar tables were prepared for each of the other industrial
countries.35 They are all based on average figures for 1970 and 1972, or
for 1970 and 1973.
There appears to be a fairly high degree of trade overlap among the
industrial countries, especially among the European nations, but the
pattern is much more pronounced among the six original members of the
European Economic Community (EEC). The tables reveal an extreme
form of intra-industry (as against inter-industry) specialization among
them. This is a phenomenon that has been commented upon in previous
34
A (0.40 X 15 per cent =0 6 per cent rise in dollar import prices and a
(0.60
35
X 60 per cent =) 9 per cent rise in dollar export prices.
These are available upon request from the author, whose address is Depart-
ment of Economics, Michigan State University, East Lansing, Michigan 48823.

FABLE 5. FRANCE: EXPORTS TO 15 INDUSTRIAL COUNTRIES, 1970-72
326
M>
d
| i ^
§ 8 1 1
2 j* 5
1 1« i
INTERNATIONAL MONETARY FUND STAFF PAPERS

VJ >»
•o
u¿¡
t_l
«j c s
Ό "8
*z e •c ü
c
3
•a o> 5 ω
ΰ
'5 S
Q. •s
c o> >f
13 ·£ω o '5 'S
3
ζ
0)
ΰ D c3
< Q E Ü á Ζ C/3 £ D
Canada 84% 76 82 80 83 64 71 65 66 77 82 69 71
United States 97% 86 89 93 92 72 81 71 75 84 90 76 80
451
Japan 84 68 80 68 69 58 64 58 59 65 72 61 68
309 364
Austria 90 84 79 90 92 74 88 64 79 80 87 72 78
337 471 322
Denmark 94 87 84 90 95 78 83 66 82 94 91 84 86
378 464 322 437
Finland 88 82 75 86 91 66 74 56 69 84 88 67 76
309 363 249 348 369
Belgium-Luxembourg
l
98 98 90 96 99 98 99 99 99 98 97 99 98
670 395 547 545 413
Germany, Fed. Rep. 98 98 90 96 99 98 99 99 99 97 97 99 98
478 671 397 548 545 415 1,029
Italy 98 97 90 98 98 98 97 97 98 96 96 97 96
469 658 393 538 538 411 954 956
Netherlands 98 96 88 95 98 98 96 98 97 97 97 97 97
464 637 383 532 536 407 903 897 845
Norway 90 83 74 84 92 94 71 80 62 76 90 82 83
320 377 259 366 388 327 440 440 434 435
Sweden 96 89 82 91 96 96 74 83 64 82 90 82 88
404 505 331 460 479 386 592 595 584 581 400
Switzerland 98 96 90 98 99 98 96 98 98 98 97 95 97
472 650 388 542 537 407 941 944 887 847 436 579
United Kingdom 97 92 88 94 91 94 92 94 90 95 93 94 95
457 619 378 sit 520 -m 801 RIO 776 752. 421 559 771
HOW TO READ THE TABLE:

Observe the upper left-hand corner. There are 451 five-digit Standard International Trade Classification items that France exports to both
the United States and Canada (items common to both destinations). They comprise 97 per cent of total French exports to Canada and 84
per1 cent of total French exports to the United States.
Consolidated figures were used for Belgium and Luxembourg since these were the only figures available for the two countries.

TABLE 6. FRANCE: IMPORTS FROM 15 INDUSTRIAL COUNTRIES, 1970-72
Sjnoquisxni-uiniSpg
•dan 'paj '¿UEUUSQ
uiopguix pajmn
sajEjg Pellín
sput?iJ3qj3N
puejjazjiMs
>IJBUIU3Q
EFFECT OF EXCHANGE RATE CHANGES ON TRADE

XBMJO
uapaMg
puejinj
epeire^
fcujsny
UEctef
¿ΙΕΪΙ
United States 84% 95 92 92 95 89 94 93 85 93 91 94 84
Canada 65% 42 53 67 85 42 57 48 45 74 49 56 64
241
Japan 56 19 63 77 26 61 75 75 56 45 81 68 40
396 156
Austria 48 23 57 65 56 56 65 67 50 56 60 58 35
294 131 221
Denmark 51 36 61 65 31 41 60 52 55 49 69 58 54
277 132 213 164
Finland 23 50 21 24 43 28 29 24 32 58 39 29 62
116 72 78 78 72
91 98 98 96 90 92 97 89
Belgium-Luxembourg l 93 94 92 90 95
707 244 405 306 293 117
92 99 97 96 96 99 99 99 96 99 99 90
Germany, Fed. Rep. 95
783 249 445 329 300 125 917
47 95 94 90 64 93 95 92 72 96 90 65
Italy 83
695 226 432 314 289 108 796 872
Netherlands 90 77 85 94 93 88 97 96 95 86 91 91 86
675 229 388 292 210 114 769 815 719
Sweden 62 54 68 71 86 90 68 77 65 63 74 74 76
370 169 253 230 221 108 396 411 382 310
61 86 89 89 85 81 87 86 73 86 91 50
Switzerland 81
568 207 364 278 269 105 626 690 629 581 357
92 92 92 61 91 94 90 88 78 95 75
United Kingdom 88 82 603
682 237 402 300 284 112 731 803 720 677 386
55 37 58 64 90 37 47 36 37 76 64 47
Norway 40 149 169
167 101 116 100 106 78 177 182 162 166 144
HOW TO READ THE TABLE: . , . ,,, - t nnn.

Observe the upper left-hand corner. There are 241 five-digit Standard International Trade Classification items (out oí a total oí over l UUuj
which France imports from both Canada and the United States (items supplied by both source countries). These comprise 65 per cent or total
French
1
imports from the United States and 84 per cent of total French imports from Canada.
327
Consolidated figures were used for Belgium and Luxembourg since these were the only figures available for the two countries.

studies of the pattern of EEC trade. In the tables prepared for France,
the Federal Republic of Germany, Italy, Belgium-Luxembourg, and the
Netherlands (on both the export and the import sides), the six EEC mem-
ber countries are shown to export to, and import from, each other almost
the entire range of potentially traded goods. The extreme level of trade
overlap among EEC members in the case of French exports and imports
is underscored in the middle of Tables 5 and 6, where boxes enclose the
data for five of France's EEC trading partners.
It should be noted that a very high trade overlap requires that, in both
supplier (or destination) countries in the pair, the common bundle of
products supplied to the market in question forms a large proportion
(usually over 95 per cent) of the country's total exports to (imports from)
that market. This condition is important because a high proportion in
only one of the two countries may merely reflect the large size and
economic diversification of the other country in the pair. That condition is
invariably met among the original EEC members. For further emphasis,
Table 7 extracts the trade overlap figures of four of Belgium's EEC part-
ners from the Belgian matrices. With the possible exception of Italy, very
high overlap is observed throughout. The same pattern holds for the trade
of the Federal Republic of Germany, Italy, and the Netherlands. No other
group of countries (such as the European Free Trade Association or the
Scandinavian countries) exhibits such a consistent lack of inter-industry
specialization. Unfortunately, comparable figures are not available for,
say, the early 1960s that would enable one to observe the developments
that have taken place over time.
All countries examined show a far greater trade overlap in their exports
than in their imports. In other words, countries appear to be much more
TABLE 7. BELGIUM: DEGREE OF OVERLAP IN TRADE WITH FOUR MEMBERS

OF EUROPEAN ECONOMIC COMMUNITY, 1970-72
(In per cent)
Exports Imports
Germany, Nether- Germany, Nether-
France Fed. Rep. Italy lands France Fed. Rep. Italy lands
France 99 98 99 100 99 97
Germany 99 99 99 100 99 99
Italy 94 94 92 76 88 79
Netherlands 99 99 99 97 99 99
HOW TO READ THE TABLE:
Observe the upper left-hand corner on the export (left) side of the table. 99 per cent
of Belgium exports to France are products that Belgium also exports to Germany.
Likewise, a full 100 per cent of Belgian imports from France are products that Belgium
also imports from Germany.

specialized in the sources of their imports than in the destinations of their

exports. This is true for all countries examined here, including the small
European nations. On the export side, the Federal Republic of Germany
appears to have the highest trade overlap; it exports practically all poten-
tially traded goods to all the European countries. It "blankets the world"
with its exports much more than any other country, including the United
States.

1020 7635 Article A002 en

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

1020 7635 Article A002 en

Uploaded by

Copyright:

Available Formats

The Effect of Exchange Rate

Changes on the Prices and Volume

I. Problem and Conceptual Framework

W ITHIN THE TRADITION of the elasticity approach to the balance of

* Mr. Kreinin is a professor of economics at Michigan State University. He

©International Monetary Fund. Not for Redistribution

"monetary" approach (which centers attention on long-run equilibrium

2. SOME A PRIORI REASONING

In theoretical, partial equilibrium terms, the pass-through effect

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

Mimdelí-Laffer (M-L) hypothesis, was developed by (or is attributed to)

©International Monetary Fund. Not for Redistribution

manufactured product having similar characteristics is less than infinite,

©International Monetary Fund. Not for Redistribution

3. METHODOLOGY—A GENERAL DISCUSSION

While other students of the subject have employed econometric

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

II. Approach and Estimation Formulas

Under the 1971 Smithsonian Agreement, there was a realignment of

*2See Rudolf R. Rhomberg, "Indices of Effective Exchange Rates," Staff

©International Monetary Fund. Not for Redistribution

TABLE 1. SIXTEEN OECD COUNTRIES: PERCENTAGE CHANGES IN U.S. DOLLAR

Percentage 1972 1972

©International Monetary Fund. Not for Redistribution

2. BASIC ESTIMATION FORMULA FOR BILATERAL IMPORT PASS-THROUGH

For greater generality, we introduce the following notation: {ERK and

©International Monetary Fund. Not for Redistribution

3. BIASES, ADJUSTMENTS, AND ALTERNATIVE FORMULAS

In essence, then, the control country represents developments that

©International Monetary Fund. Not for Redistribution

of revaluation. In addition to being an important trading partner of the Κ

Germany, Fed. Rep. United Kingdom

©International Monetary Fund. Not for Redistribution

As the revaluation of the control country relative to the Κ country

©International Monetary Fund. Not for Redistribution

4. ESTIMATION FORMULAS FOR BILATERAL EXPORT PASS-THROUGH

A symmetrical analysis was undertaken with respect to exports. Again,

As in the case of imports, a downward bias is introduced into 0Ρξ because

©International Monetary Fund. Not for Redistribution

of substitution in demand for Κ country products from the control

As in the case of imports, a price adjustment was deemed necessary. For

5. AVERAGING OF BILATERAL a¿ OBSERVATIONS FOR EACH Κ COUNTRY

No restrictions are imposed on the individual comparisons; only aver-

for imports ( represents imports of K)K)

ΌΓ exports (XK represents exports of K)

Yet another method of averaging the individual ai observations is by

where Ρ represents the differential percentage price change between the ι

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

when ER = 15 per cent, Ρ = 11.63, and the pass-through is estimated

6. ESTIMATION OF TRADE VOLUME AND ELASTICITIES

With respect to the quantity Q of trade, the control country approach

©International Monetary Fund. Not for Redistribution

both in percentage terms—would yield an estimate of the elasticity of

for each pair of suppliers i and / (covering matched products), where b

III. Data and Computational Procedures

All observations employed in this paper relate to percentage changes

©International Monetary Fund. Not for Redistribution

that are as disaggregated as possible. Only high disaggregated products are

©International Monetary Fund. Not for Redistribution

commodity bundle common to both of them. The procedure is best