Theoretical Framework

Pass-through effects can only be achieved in a non-competitive market. In a perfectly competitive market, exporters face a perfectly elastic demand curve and have no pricing powers. It is impossible for exporters to transfer any part of rising costs due to home currency appreciations. Monopolistic powers associated with imperfect competition allow exporters to adjust prices following variations of exchange rates. Further, firms with pricing power earn a markup over marginal costs. The phenomenon of exchange rate pass-through is generally analyzed with standard markup models.

Assume that the marginal cost of PRC exporters is MC measured in yuan and with markup rateΔ, their export price in terms of terms can be defined as

Import prices of foreign buyers are a transformation of the export price with exchange rates. Let E be the nominal exchange rate, the yuan's unit value measured in foreign currencies, the import price in terms of foreign currencies can be expressed as

Taking logarithm on both sides of equation (1) yields

Let lower cases of the corresponding variables denote their values in logarithm, the above equation can be simplified as

Based on equation (3), a simple econometric model used for testing pass-through can be derived as

The coefficient of e_t measures the responsiveness of import prices to exchange rate variations. If β is equal to one, pass-through is complete; if β is less than one, pass-through is incomplete. For capturing gradual adjustment of import prices and controlling non-stationarity of all underlying variables, model (4) was transformed into first difference with lagged marginal costs and nominal exchange rates as

In the above dynamic model, β₀ measures the short run elasticity of import prices to exchange rates, and the sum of the coefficients on the contemporaneous exchange rate and lags of exchange rates indicates the long run elasticity. We first estimated equation (5) for both the US and Japan to examine pass-through effects of the yuan's appreciation.

The data used in estimations are collected from various sources. The US Bureau of Labor Statistics has compiled monthly price indexes of imports from the PRC from 2004. Nominal exchange rates of the yuan against the dollar and Japanese yen were retrieved from PACIFIC Exchange Rate Service. There is no direct measurement on marginal costs of PRC exporters. It was suggested to use unit labor cost as a proxy for marginal costs of PRC exports. However, the unit labor cost data were not available. Instead, monthly producer price indexes (PPI) of the PRC were used as a proxy of the marginal cost. In the macroeconomic literature (e.g., Monacelli [2005]), prices paid by importers are defined as marginal costs of the importers. In the empirical literature on pass-through effects, PPI or the consumer price index (CPI) are used as an acceptable proxy for marginal costs (e.g., Vigfusson, Sheets, and Gagnon [2007]; Gopinath, Itskhoki, and Rigobon [2008]). PPI data were downloaded from the CEIC data base. The Japanese Ministry of Finance compiles not only aggregated price indexes of all imports from the PRC, but also the price indexes of different commodity groups. In the case of Japan, the regression model was estimated for all imports as well as imports in food, raw materials, apparel, manufacturing and machinery. Moreover, sectoral PPI were used for each corresponding sectors and the monthly time series data range from 1998 to 2008.

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