Exchange Rate Pass-through

Exchange rate pass-through is the extent to which a change in the exchange rate is transmitted to the prices of imported goods and, through them, to domestic prices. The degree of pass-through determines the effect of exchange rate movements on inflation and on the trade balance.

Concept

Pass-through is measured as the proportion of a change in the exchange rate that is reflected in the price of imports in the domestic currency. Complete pass-through means that a depreciation raises import prices by the full amount of the depreciation. Incomplete pass-through means that the effect is smaller.

Pass-through operates through the pricing decisions of exporters. An exporter who wishes to maintain a constant price in the destination currency will absorb the exchange rate change in its margin, reducing pass-through. An exporter who maintains a constant price in its own currency will pass the change through fully.

Determinants

The degree of pass-through depends on several factors. The market power of exporters matters: an exporter with market power can choose how much of the change to pass on, while an exporter in a competitive market must accept the market price.

The importance of the costs of production in the destination country matters. If a large share of the cost is incurred in the destination country, the effect of the exchange rate on the final price is smaller.

The pricing conventions of firms matter, particularly in markets where prices are set for a period. If firms set prices in the destination currency and adjust them infrequently, pass-through is delayed and partial.

Macroeconomic Implications

Pass-through is central to the analysis of the effects of exchange rate movements. A high degree of pass-through means that a depreciation raises import prices substantially and thereby increases inflation, while a low degree of pass-through means that the effect on inflation is smaller.

Pass-through also affects the trade balance. A depreciation makes exports cheaper and imports more expensive, which should improve the trade balance. The improvement depends on the response of quantities, which in turn depends on the elasticity of demand for exports and imports. The condition for a depreciation to improve the trade balance is known as the Marshall-Lerner condition.

The effect on inflation has implications for monetary policy. If pass-through is high, a depreciation may generate inflation, which the central bank must offset. If pass-through is low, the central bank has more room to accommodate the depreciation.

Evidence

Empirical evidence suggests that pass-through has declined in many countries, particularly in advanced economies. The decline has been attributed to the increasing importance of global value chains, which means that imported intermediate goods embody costs from many countries, and to the adoption of inflation targeting, which has anchored expectations and reduced the response of prices to exchange rate movements.

The evidence also suggests that pass-through is asymmetric, with larger effects for depreciations than for appreciations. This asymmetry matters for the analysis of the effects of exchange rate movements on inflation and on the trade balance.

Pass-through and Import Prices

The measurement of pass-through focuses on the relationship between exchange rates and import prices. Empirically, the relationship is estimated using time series data on exchange rates and on import prices, with controls for other determinants.

The estimates suggest that pass-through is incomplete in most countries and that it has declined over time. The decline has been attributed to the increasing role of global value chains, which means that the cost of an imported good is determined by costs incurred in many countries, and to the use of local currency pricing by exporters.

The composition of imports matters. Imports of commodities, which are priced in international markets, tend to have higher pass-through than imports of manufactured goods, which are more differentiated and more subject to pricing to market.

Pricing to Market

Pricing to market is the practice of setting different prices in different markets, in order to maintain market share or to respond to local competition. It results in incomplete pass-through, since the exporter absorbs part of the exchange rate change in its margin.

The extent of pricing to market depends on the market power of the exporter and on the structure of the market. An exporter with a strong brand and with loyal customers can maintain its price in the destination currency, absorbing the exchange rate change.

Pricing to market also depends on the invoicing currency. When trade is invoiced in the currency of the exporter, pass-through tends to be higher, since the price in the destination currency changes with the exchange rate. When it is invoiced in the currency of the importer, pass-through tends to be lower.

Pass-through and Monetary Policy

The degree of pass-through affects the conduct of monetary policy. If pass-through is high, exchange rate movements have a large effect on inflation, and the central bank must respond. If pass-through is low, the effect is smaller, and the central bank has more room to accommodate the movement.

The relationship between pass-through and monetary policy is also affected by the credibility of the policy framework. When inflation expectations are well anchored, the effect of exchange rate movements on inflation is smaller, since firms are less likely to adjust prices in response.

The decline in pass-through has implications for the transmission of monetary policy. It suggests that exchange rate movements have a smaller effect on inflation than in the past, and that the central bank may need to rely more on other channels of transmission.

Summary

Exchange rate pass-through determines the effect of exchange rate movements on import and consumer prices. Its level and its evolution matter for the analysis of inflation, of the trade balance, and of monetary policy.

See also

• Foreign Exchange Market
• Inflation
• International Trade