Exchange Rate Pass Through and Inflation

Our discussion of how the current account is determined in the DD-AA model has assumed that nominal exchange rate changes cause proportional changes in real exchange rates in the short run. Because the DD-AA model assumes that the nominal output prices P and P* cannot suddenly jump, movements in the real exchange rate, q = EP*/P, correspond perfectly in the short run to movements in the nominal rate, E. In reality, however, even the short-run correspondence between nominal and real exchange rate movements, while quite close, is less than perfect. To understand fully how nominal exchange rate movements affect the current account in the short run, we need to examine more closely the linkage between the nominal exchange rate and the prices of exports and imports.

The domestic currency price of foreign output is the product of the exchange rate and the foreign currency price, or EP*. We have assumed until now that when E rises, for example, P* remains fixed so that the domestic currency price of goods imported from abroad rises in proportion. The percentage by which import prices rise when the home currency depreciates by one percent is known as the degree of pass-through from the exchange rate to import prices. In the version of the DD-AA model we studied above, the degree of pass-through is 1; any exchange rate change is passed through completely to import prices.

Contrary to this assumption, however, exchange rate pass-through can be incomplete. One possible reason for incomplete pass-through is international market segmentation, which allows imperfectly competitive firms to price to market by charging different prices for the same product in different countries (recall Chapter 15). A large foreign firm supplying automobiles to the United States may be so worried about losing market share that iJSee the discussion of Table I6AIII-I in Appendix III.

it does not immediately raise its U S. prices by 10 percent when the dollar depreciates by 10 percent, despite the fact that its revenue from American sales, measured in its own currency, will decline. Similarly, the firm may hesitate to lower its U.S. prices by 10 percent after a dollar appreciation of that size because it can thereby earn higher profits without investing resources immediately in expanding its shipments to the United States. In either case the firm may wait to find out if the currency movement reflects a definite trend before making price and production commitments that are costly to undo. In practice, many U.S. import prices tend to rise by only around half of a typical dollar depreciation over the following year.

We thus see that while a permanent nominal exchange rate change may be fully reflected in import prices in the long run, the degree of pass-through may be far less than I in the short run. Incomplete pass-through will have complicated effects, however, on the timing of current account adjustment. On the one hand, the short-run J-curve effect of a nominal currency change will be dampened by a low responsiveness of import prices to the exchange rate. On the other hand, incomplete pass-through implies that currency movements have less-than-proportional effects on the relative prices determining trade volumes. The failure of relative prices to adjust quickly will in turn be accompanied by a slow adjustment of trade volumes.

Notice also how the link between nominal and real exchange rates may be further weakened by domestic price responses. In highly inflationary economies, for example, it is difficult to alter the real exchange rate EP*!P simply by changing the nominal rate E, because the resulting increase in aggregate demand quickly sparks domestic inflation, which in turn raises P. To the extent that a country's export prices rise when its currency depreciates, any favorable effect on its competitive position in world markets will be dissipated. Such price increases, however, like partial pass-through, may weaken the I-curve.

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