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Literature Review

Exchange rate pass-through is defined as the percentage change in local currency import prices due to a 1% change in the exchange rate between exporting and importing countries. If import prices respond to exchange rate variation one for one, the pass-through is complete. Constant marginal costs and constant markups of prices over the cost are required conditions to warrant complete pass-through (Goldberg and Knetter [1997]). However, there is no empirical evidence to support a complete pass-through hypothesis. When import prices partially reflect changes in exchange rates, it is referred to in the literature as incomplete exchange rate pass-through.

Theoretical studies on exchange rate pass-through phenomena have been based on models of industrial organizations and emphasized market structures and firms pricing behaviors. Assuming that exchange rate shocks are exogenous, Dornbusch (1987) showed that, in a Cournot model the pass-through effect is larger the more competitive the industry and the larger the share of imports in total sales. Yang (1995) applied an adapted Dixit-Stiglitz model to address the role of product differentiations in pass-through behaviors. The analysis suggested that, exchange rate pass-through is higher in industries with a higher degree of product differentiation and a lower elasticity of marginal cost.

Froot and Klemperer (1989) linked the exchange rate pass-through with foreign firms market shares in a dynamic model. They examined pricing behaviors of export firms under temporary and permanent exchange shock scenarios. Export firms tend to transmit less exchange rates shocks to prices if they perceive that the exchange rate changes are temporary. On the other hand, permanent exchange rate variations will encourage export firms to lower their prices when the local currency appreciates in order to maintain their market shares.

There is a plethora of empirical research estimating pass-through effects, most of which focus on industrialized countries. Campa and Goldberg (2003) investigated the effect of exchange rate pass-through on the import prices of 23 Organisation of Economic Co-operation and Development (OECD) countries. They reported that the unweighted average of pass-through elasticities across OECD countries was approximately 46% over one quarter, and 64% over the longer-term. The US has the lowest pass-through rates in the OECD, at approximately 25% in the short run and 40% in the long run.

Strategic behaviors of export firms also play critical roles in determining degrees of exchange rate pass-through. To maintain price stability, export firms may absorb exchange rate shocks by adjusting their markups. Destination-specific adjustment of markups in response to exchange rate changes is a practice used by export firms which engage in price discrimination across export destinations. It is referred as “pricing-to-market” (PTM) in the literature. PTM works as the following: if exporters' currency appreciates against that of the importers, they reduce their markups of price over marginal cost so as to stabilize prices in the local currency of importers (Knetter 1993). Market competition and elastic demand compel exporters to discipline their price behaviors and limit their ability to pass on rising costs due to exchange rate fluctuations. Gagnon and Knetter (1991) found that Japanese auto exporters offset approximately 70% of the effect of exchange rate changes on buyers' prices through markup adjustment.

Besides the declining “pricing power,” Taylor (2000) argued that, the decline in inflation in many countries contributed to low pass-through rates. A low inflation environment lessens the expected persistence of cost and price changes, resulting in low pass-through. By examining export prices denominated in exporters' currencies, Vigfusson, Sheets, and Ganon (2007) showed that prices of exports to the US are more responsive to exchange rate changes than that of exports to other markets, and country and region-specific factors affected degrees of pass-through.

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