NBER WORKING PAPER SERIES EXCHANGE RATE PASS-THROUGH INTO IMPORT PRICES: A MACRO OR MICRO PHENOMENON? José Manuel Campa Linda S.

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1 NBER WORKING PAPER SERIES EXCHANGE RATE PASS-THROUGH INTO IMPORT PRICES: A MACRO OR MICRO PHENOMENON? José Manuel Campa Linda S. Goldberg Working Paper 8934 hp:// NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachuses Avenue Cambridge, MA May 2002 The views expressed in his paper are hose of he individual auhors and do no necessarily reflec he posiion of he Federal Reserve Bank of New York or he Federal Reserve Sysem. We hank Rudiger Dornbush, Richard Marson, Andrew Rose and Alwyn Young for helpful commens, as well as he seminar paricipans a various universiies, he ASSA, NBER, BIS, and Federal Reserve Bank of New York. We also hank Leicia Alvarez and Glenda Oskar for heir research assisance. The views expressed herein are hose of he auhors and no necessarily hose of he Naional Bureau of Economic Research by José Manuel Campa and Linda S. Goldberg. All righs reserved. Shor secions of ex, no o exceed wo paragraphs, may be quoed wihou explici permission provided ha full credi, including noice, is given o he source.

2 Exchange Rae Pass-Through ino Impor Prices: A Macro or Micro Phenomenon? José Manuel Campa and Linda S. Goldberg NBER Working Paper No May 2002 JEL No. F3, F4 ABSTRACT Exchange rae regime opimaliy, as well as moneary policy effeciveness, depends on he ighness of he link beween exchange rae movemens and impor prices. Recen debaes hinge on wheher producer-currency-pricing (PCP) or local currency pricing (LCP) of impors is more prevalen, and on wheher exchange rae pass-hrough raes are endogenous o a counry's macroeconomic condiions. We provide cross-counry and ime series evidence on boh of hese issues for he impors of weny-five OECD counries. Across he OECD and especially wihin manufacuring indusries, here is compelling evidence of parial pass-hrough in he shor-run- rejecing boh PCP and LCP. Over he long run, PCP is more prevalen for many ypes of impored goods. Higher inflaion and exchange rae volailiy are weakly associaed wih higher pass-hrough of exchange raes ino impor prices. However, for OECD counries, he mos imporan deerminans of changes in pass-hrough over ime are microeconomic and relae o he indusry composiion of a counry's impor bundle. José Manuel Campa Linda S. Goldberg IESE Business School Federal Reserve Bank of New York Camino del Cerro del Aguila 3 Research Deparmen Madrid 33 Libery Sree Spain New York, NY and NBER and NBER Tel: Fax: Linda.Goldberg@ny.frb.org

3 1. Inroducion While exchange rae pass-hrough has long been of ineres, he focus of his ineres has evolved considerably over ime. Afer a long period of debae over he law of one price and convergence across counries, beginning in he lae 1980s exchange rae pass-hrough sudies emphasized indusrial organizaion and he role of segmenaion and price discriminaion across geographically disinc produc markes. More recenly pass-hrough issues play a cenral role in heaed debaes over appropriae moneary policies and exchange rae regime opimaliy. 1 These debaes hinge on he issue of he prevalence of producercurrency-pricing (PCP) versus local currency pricing (LCP) of impors, and on wheher exchange rae pass-hrough raes are endogenous o a counry s inflaion performance. Low impor price pass-hrough means ha nominal exchange rae flucuaions may lead o lower expendiure swiching effecs of domesic moneary policy, hereby leaving moneary policy more effecive for dealing wih real shocks. If pass-hrough raes are endogenous o a counry s relaive moneary sabiliy, he exen of his moneary policy effeciveness may be fragile and regime-specific. 2 The firs goal of our paper is o provide exensive cross-counry and ime-series evidence on exchange rae pass-hrough ino he impor prices of 25 OECD counries. Using quarerly daa from 1975 hrough 1999, we documen he prevalence of PCP and LCP in shor-run and long-run pass-hrough elasiciies. We use an economically meaningful esimaion approach, meaning ha we esimae pass-hrough raes afer conrolling for exporer marginal cos shifers. A he level of an aggregaed impor bundle, he evidence across counries is srongly supporive of parial exchange rae pass-hrough in he shor run (defined as one quarer). The unweighed average of pass-hrough elasiciies across he OECD counries is abou 60 percen over one quarer, and abou 75 percen over he longer erm. The Unied Saes has among he lowes pass-hrough raes in he OECD, a abou 25 percen in he shor run and 40 percen over he longer run. Corresponding raes of pass-hrough ino German impor prices are approximaely 60 percen in he shor run and 80 percen in he long run. We find ha 1 The implicaions of pass-hrough performance for opimal moneary policy also is explored in Corsei and Peseni (2001), Obsfeld (2000), Devereux (2000), and Devereux and Engel (2000), among ohers. 2 See Taylor (2001). The role of he invoicing decisions of producers in influencing pass-hrough raes is explored in recen work by Devereux and Engel (2001) and Bacchea and vanwincoop (2001). 2

4 rankings of elasiciies are no ighly correlaed wih counry size, especially when he composiion of counry impor bundles differs subsanially. A a more disaggregaed indusry level, we reach similar conclusions abou he prevalence of parial pass-hrough ino impor prices. There is srong evidence agains boh PCP and LCP as shor-run descripions of pass-hrough ino Manufacuring and Food impor prices. Wih manufacuring rade now so pervasive for OECD counries, hese resuls drive he parial pass-hrough observed in almos all counries. Non-manufacuring and Raw Maerial impors generally rejec LCP, and are mixed on rejecions of PCP. Such findings are consisen wih inuiion abou pass-hrough raes ino producs ha are ofen invoiced in dollars. The second goal of our paper is o provide insighs ino he forces underlying crosscounry differences in pass-hrough raes and changes in pass-hrough elasiciies over ime bu wihin counries. An inriguing hypohesis posed by John Taylor (2001) is ha passhrough of coss ino markups is endogenous o a counry s inflaion performance. The imporan implicaion is ha here is a viruous -- bu fragile -- circle wherein low inflaion (variabiliy) leads o reduced markups, less inflaionary implicaions of moneary expansions, and coninued low markups. Taylor argues ha if declines in pass-hrough are a produc of he low inflaion environmen of recen years (which in urn is associaed wih less persisen inflaion), recen gains in price sabiliy can be fragile and poenially eliminaed by adverse price shocks. As an alernaive o his view, if pass-hrough raes decline due o more srucural reasons such as declining pricing power of firms, he recen regime of price sabiliy may be more robus. Similarly, even wihou changes in he compeiive srucures of indusries, he pass-hrough elasiciies on impor baskes can change purely in line wih changes in he composiion of he impor baske if he componen producs have disinc pass-hrough elasiciies. Ulimaely, we conclude ha while he Taylor argumen has some saisical meri when properly esed, i is no of firs order imporance for he low and medium inflaion counries of he OECD. Firs, despie lower inflaion in many OECD counries in recen years, declining exchange rae pass-hrough ino impor prices has no been a general feaure of he OECD counries. Levels of pass-hrough by counry are significanly higher in counries wih higher nominal exchange rae variabiliy consisen wih recen heoreical advances on he opimal choice of invoicing currency -- bu largely uncorrelaed wih levels of inflaion, money growh raes, or aggregae counry size. Alhough changes in some of 3

5 hese macro series are weakly correlaed wih changes in pass-hrough, hese macro variables are no of firs order imporance in explaining pass-hrough evoluion wihin he OECD over he pas 25 years. Far more imporan for overall pass-hrough raes are changes in he composiion of indusries in a counry s impor baske. In paricular, he move away from energy as a high proporion of he impor bundles, o a much higher share for manufacured producs, has been he primary driver behind recen pass-hrough changes ino impor prices among numerous OECD counries. 3 The indusry composiion of rade is more srucural han is inflaion performance. Consequenly, hose OECD counries ha have brough down heir pass-hrough elasiciies hrough changes in rade composiion have pass-hrough reducions (and consequen implicaions for moneary policy) ha are more robus o he inflaion regime. Moneary policy ransmission herefore is expeced o be robus o he exen ha indusry pass-hrough raes remain sable, mainly evolving wih he produc mix of each counry s rade. 2. Exchange Raes and Prices: Similar Equaions, Differen Inerpreaions Analyses of exchange raes and price linkages have followed numerous pahs, ranging from early macroeconomic debae on exchange raes and monearism, o marke inegraion or segmenaion associaed wih he law of one price, o he role of marke microsrucure in he abiliy and desire of producers o price discriminae. Empirical ess of associaed hypoheses revolve around he familiar equaion: P = E P * (1) where P is he domesic price index, currency per uni of foreign), and E is he nominal exchange rae (defined as domesic * P represens foreign prices. (Relaive) purchasing power pariy ess use price indices across counries o es wheher his relaionship holds. Law of One Price hypoheses es he same equaion for individual goods raded across counries. As nicely discussed in P. Goldberg and Kneer (1997), coss of ransporaion or resale (such as 3 Our focus should no be confused wih ha of relaed recen papers ha aemp o explain he pass-hrough of exchange raes ino a counry s CPI. In hese papers, exchange rae movemens lead o impor price passhrough. These ener wih weighs ino he aggregae CPI of counries, wih he weighs possibly o be adjused o reflec disribuion coss as in Bursein, Neves, and Rebelo (2001) or cenral bank reacion funcions as in Gagnon and Ihrig (2001). 4

6 rade barriers) migh preclude price equalizaion bu give rise o a sable wedge beween indices. Exchange rae pass-hrough sudies consider he exen o which exchange rae movemens are passed-hrough ino raded goods prices, versus absorbed in producer profi margins or markups. Ofen hese sudies look a indices of indusrial concenraion or marke power o explain pass-hrough differences or pricing-o-marke. The exbook definiion of exchange rae pass-hrough (ERPT) is he percen change in local currency impor prices resuling from a one percen change in he exchange rae beween he exporing and imporing counry. Evidence on ess of his relaionship rely on he γ esimaes based on a simple equaion p = γ e + ε (2) where all lower-cased variables are in logs and ε is an error erm. 4 Despie is populariy, his reduced form equaion (wheher in log levels or growh raes) is problemaic for hypohesis esing because i represens a non-srucural saisical relaionship. The micro-foundaions of pricing behavior by exporers are a beer saring poin for generaing he more economically meaningful specificaions ha are appropriae for hypohesis esing. The pricing equaion of a exporer from counry x -- and is elasiciy of response o an exchange rae movemen -- depend on he srucure of demand and coss confroning he exporer. If he impor prices of counry j, P he pricing rule of he foreign exporers x supplying j is: m, j, are he dependen variables, ( ) (,, ) P = E P = E Mkup P P C W Y E m, j x, j x, j m, j x, j j P where MKUP, C > 0, C < 0, C > 0. x, j x, j x, j x, j x, j x, j w E y C (3) In equaion 3 MKUP represens he markup rae of prices over coss for he x, j exporer. Markup raes are indusry specific and depend on he demand curve facing exporers x in counry j. This demand depends, in urn, on P m, j P, he prices of impors 4 The γ s are background informaion for he moneary policy debae discussed in Taylor (2001) and provided in sudies such as McCarhy (2000). While Taylor argues ha exchange rae pass-hrough elasiciies appear o have declined over ime for counries ha have reduced heir inflaion levels and inflaion variabiliy, here had no been sysemaic analysis verifying his asserion. 5

7 relaive o prices of counry j producers. C is he marginal cos funcion of he exporer in x, j his own currency. This exporer marginal cos funcion is increasing in expor marke wages, W x, j, and increasing in counry j demand condiions Y. 5 The exchange rae is an argumen in he exporer s cos funcion o he exen ha he exporer relies on impored inpus or has oher coss ha move wih he relaive value of he desinaion marke currency. 6 Differeniaion of (3) yields an expression of he form x, j x, j x, j x, j m, j EC E x, j W C x, j YC w y P = 1+ x, j E + MKUP + W x, j + Y x, j C C C (4) where. over a variable represens a percenage change. Equaion 4 clearly demonsraes ha empirical specificaions ha seek o isolae pass hrough elasiciies should inroduce conrols for he exogenous cos shifers enering ino foreign exporer pricing decisions. Wihou such conrols he measured relaionship is a saisical correlaion wihou specific economic inerpreaion in erms of exchange rae pass-hrough. Furher manipulaion of (4) gives microfounded inuiion behind pass-hrough elasiciies ino impor prices. 7 Muliplying hrough by E P and rearranging erms, he exchange rae pass hrough elasiciy γ is a funcion of he markup and foreign marginal cos elasiciies, η and λ : m, j 1+ λ γ = 1 η (5) where P γ = E m, j m, j P E, Mkup η = Markup x, j x, j 0,, m j m j ( P P ) ( P P) (negaive for normally shaped x j C demand, which is less convex han consan elasiciy curves), and λ = E, x, j C E 0. Any force ha makes foreign marginal coss more sensiive o exchange raes makes local currency impor prices less sensiive o exchange raes. The inuiion behind his 5 More precisely, one should include as he appropriae demand variable an index of income levels across he producer s home marke and he desinaion marke for is expors. Since we do no have informaion on he composiion of demand facing exporers in differen counries, our proxy here is he GDP of he imporing counry. 6 See Campa and Goldberg (1997), Feensra (1998), and Hummels, Ishii and Yi (2001) for evidence on increasing reliance on impored inpus and verical inegraion of producion across counries. 7 Our hanks o Richard Marson for suggesing he inclusion of his elasiciies inerpreaion. 6

8 saemen is ha an exporer ha relies more on impored inpus has a smaller share of local value-added in coss ha can flucuae wih exchange raes. Also, exporers facing highly elasic demand curves will pass-hrough a lower percenage of exchange rae changes ino desinaion marke prices. An example is he small exporer supplying a large marke populaed wih local compeiors. Clearly, exchange rae pass-hrough depends on he srucure of compeiion in he indusry, as has been exposied simply and eloquenly in Dornbusch (1987) and Marson (1990), among ohers, and suppored empirically by Kneer (1993) and Yang (1997). 3. Exchange Raes and Impor Prices: The Evidence A. The Daa and Esimaion Mehodology. We capure he argumens of equaion (4) hrough a log-linear regression specificaion similar o ha esed hroughou he exchange rae pass-hrough lieraure: 8 p = α + δx + γe + ϕz + ε (6) where p are local currency impor prices, e is he exchange rae, x is a primary conrol variable represening exporer coss, and Z is a vecor of oher conrols, including real GDP of he desinaion marke. Biased esimaes of he pass-hrough coefficien could arise if foreign wages or GDP are correlaed wih exchange raes bu omied from he regression. Our approach considers pass-hrough ino impor prices of specific counries, as opposed o oher careful empirical sudies of exchange rae pass-hrough ha focus exclusively on he expor prices of individual producs or baskes from a single counry o a number of desinaion markes. 9 We pursue he impor price approach because i is he more relevan dependen variable in he debae on he inflaionary consequences of exchange rae flucuaions. Our dependen variables are impor uni value indices (aggregaed across all impors, and disaggregaed ino major indusry groups) for 25 OECD counries. 8 P.Goldberg and Kneer (1997) overview he relaionships beween hese sudies. Beyond he indusrial organizaion hemes, here also are sudies ha allow for pass-hrough elasiciies o differ beween appreciaion and depreciaion periods (Swamy and Thurman 1994) or o be disinc for anicipaed versus unanicipaed exchange rae changes (Marson 1990). 9 Kneer (1993), Marson (1990), P.Goldberg and Kneer (1996), and Kasa (1992) use expor prices or expor uni values from specific counries o muliple desinaions wih he inen of idenifying price discriminaion or pricing o marke aciviy. While imporan in cross-counry research, price discriminaion across markes also is a heme wihin counries and across ciies. For example, see Engel and Rogers (1996). 7

9 The OECD compiles quarerly daa on impor price indices for OECD counries, wih he series commencing around 1975 and ending in In addiion o he counry aggregaes, he OECD also repors disaggregaed impor prices a he counry level for five produc caegories: Food, Energy, Raw Maerials, Manufacuring, and Non-Manufacuring producs. Since we ulimaely find ha energy pass-hrough elasiciies exhibi anomalous behavior, we delve furher ino he prices of disaggregaed energy impors. For cross-counry comparisons, daa allow for furher disaggregaion ino Seam Coal, Coking Coal, and Crude Oil (daa source: Inernaional Energy Agency). Nominal exchange raes are from he Inernaional Financial Saisics (series neu), defined in our specificaions as domesic currency per uni of foreign currencies (1/neu), so ha home currency depreciaions appear as increases in he nominal exchange rae series. The real GDP series used are hose of he imporing counries (source: Inernaional Financial Saisics). I is more difficul o find a primary conrol variable ha capures he shifing relaive coss of a counry s rading parners. We consruc a consolidaed expor parners cos proxy by aking advanage of he IFS reporing of boh real reu and nominal neu exchange rae series and compuing W = neu P reu by counry in our sample. This x, j j j j gives us a measure of rading parner coss (over all parners x of imporing counry j), wih each parner weighed by is imporance in he imporing counry s rade. For each of hese counry impor price indices, he firs sage of our analysis enails esimaing shor-run and long-run pass-hrough elasiciies, γ, from equaion (6). 10 We esimae hese elasiciies across 25 counries, and perform ess for srucural changes in he esimaed pass-hrough raes during he sample period. We hen run second sage regressions o explain cross-counry and ime series differences in pass-hrough performance wih explanaory variables ha include moneary aggregaes and also emphasize he imporance of he composiion of a counry s impor bundle. The firs-sage regressions are specified o generae pass hrough elasiciies and o follow equaion (6), expressed in firs-differences, wih he addiion of lagged exchange rae 10 These elasiciies have a direc economic inerpreaion, in conras wih he saisical measures ha would be generaed by an equaion such as (2). We noneheless also generaed saisical pass-hrough elasiciies o deermine wheher hese differed subsanially from he elasiciies repored in he ex. The differences were someimes subsanial, bu were no sysemaically posiive or negaive biased across counries. 8

10 and foreign producion cos erms o allow for he possibiliy of gradual adjusmen of impor prices o exchange raes 11 : 4 4 j j j j j j j j α i i i i ϑ i= 0 i= 0 p = + a e + b w + c gdp + The shor-run relaionship beween exchange raes and he impor prices of counry j is given j by he esimaed coefficien a 0. The long run elasiciy is given by he sum of he coefficiens on he conemporaneous exchange rae and four lags of exchange rae erms i= 4 0 j a i. 12 The esimaion mehodology applied is ordinary leas squares on variables in log differences, seleced afer we performed exensive checks on he saionariy of series and on appropriaeness of a coinegraion approach. 13 We were unable o rejec he hypohesis ha he (log) series of impor prices, foreign coss, and effecive exchange raes were nonsaionary. We performed addiional ess o deermine wheher hese hree variables were coinegraed, i.e. wheher a linear combinaion of hese variables resuled in a saionary process. 14 Absracing from he issue of low power of hese ess, and despie predicions of heory, we rejeced he coinegraion hypohesis and consequenly did no apply an error correcion model. (7) B. Exchange Rae Pass-Through ino Impor Prices. Esimaes of exchange rae passhrough ino impor prices for he OECD counries are presened in Table 1. Taking unweighed averages across counries, we find ha average pass-hrough ino impor prices is 11 We include up o hree lags of exchange raes and foreign prices/producion coss in he regression. Mos of he pass-hrough response occurs over he firs and second lags afer an exchange rae change, so he inerpreaion of four quarers as long run is empirically validaed. An alernaive specificaion, which used a lagged dependen variable and relied on a parial adjusmen model, generaed very similar empirical resuls (no repored in his version of he paper). 12 While he heoreical anecedens of his equaion are log-level relaionships among variables, for esimaion he variables in hese equaions are firs-differenced o conrol for he possibiliy of uni roos in he ime series variables conained in hese specificaions. 13 Dickey Fuller Uni roo ess on he logarihmic values of he impor price, foreign coss, and exchange rae series in an economeric specificaion, wih ime rends, rejec he uni roo hypohesis a he 5% level in only 3 of 150 insances. This is clearly below he saisical error for 150 specificaions, which would be 7.5 rejecions. We herefore accep ha he (log) series of impor prices, foreign coss, and effecive exchange raes are nonsaionary, wih he srong cavea ha hese saionariy ess have low power. 14 We rejec ha he log real exchange rae is saionary and ha he vecor (1,1,-1) is a coinegraing vecor as suggesed by he heory on he real exchange rae. Of course, if here is a coinegraing vecor i may differ from wha his heory predics. We run a model where p() = a + b*e() + c*w() + u(), and compue () = ρ* (-1) + e(). We es wheher he esimaed coefficien, ρ, is differen from uniy, and rejeced for only 11 cases 9

11 0.61 in he shor-run and 0.77 in he long-run. These averages mask ineresing cross-counry differences in pass-hrough ino impor prices. The Unied Saes has relaively low passhrough, 26 percen wihin one quarer and abou 41 percen over he longer run. Pass hrough esimaes for counries such as France, Germany, and Swizerland are closer o 60 percen in he shor run and 80 percen over he longer run. Smaller European counries ypically have even higher pass-hrough raes, bu a precise relaionship beween passhrough and counry size is no empirically significan. A recurren issue in he macroeconomics lieraure is he prevalence of local currency price sabiliy (LCP) versus producer currency pricing (PCP). LCP represens a null hypohesis of zero pass-hrough while PCP implies a pass-hrough of uniy. Table 2 summarizes our ess for he exisence of local currency pricing, producer currency pricing, or parial pass-hrough ino impor prices. For counries in he OECD we overwhelmingly rejec complee pass-hrough (or PCP) and zero pass-hrough (or LCP) as a descripion of aggregae impor prices in he shor run. Parial pass-hrough is he bes descripion for impor price responsiveness in he firs quarer: elasiciies of overall impor prices are significanly differen from zero in 22 ou of 25 counries and significanly differen from one for 20 ou of 25 counries. In he longer run, pass-hrough elasiciies are larger and closer o one, alhough complee pass-hrough or producer currency pricing is sill rejeced in 9 ou of 25 counries. Thus, while PCP is beer suppored as a longer run characerizaion, i is sill rejeced for many OECD counries. Recenly, numerous commenaors have speculaed ha pass-hrough raes have been declining. We address his issue direcly by performing wo ypes of srucural change ess on he pass-hrough elasiciies. We firs assume an exogenously imposed break poin in he middle of he sample and perform Chow ess. In a second se of ess we allow for endogenously deermined srucural break poins. 15 he hypohesis ha ρ is differen from uniy a he 5% level. This is slighly higher han he 7.5 insances ha saisical error would sugges, bu sill very low. 15 Hansen (2001) provides a good criique of differen ypes of srucural change ess. 10

12 Counry Table 1: Exchange Rae Pass-hrough ino Impor Prices Full Sample Pass-Through Elasiciies Change in Pass-hrough Elasiciies 1999 versus 1989 Shor Run Long-Run Shor-Run Long-Run Ausralia 0.55*+ 0.69* Ausria 1.22* Belgium * 0.18 Canada 0.65*+ 0.68* Swizerland 0.67*+ 0.94* Czech Republic 0.38*+ 0.61* Germany 0.59*+ 0.79* Denmark 0.56*+ 0.68* * Spain 0.66*+ 0.56* * Finland 0.69*+ 0.82* France 0.53*+ 1.21* -0.82* Unied Kingdom 0.39*+ 0.47* Greece Hungary 0.58*+ 0.85* 0.87* 0.93* Ireland 0.79* 1.37* Iceland 1.18* 0.76* Ialy 0.67*+ 0.62* Japan 0.88* 1.26* -0.36* -0.76* Neherlands 0.75*+ 0.77* Norway 0.51*+ 0.79* New Zealand 0.47*+ 0.62* * -0.53* Poland * Porugal 0.60*+ 0.88* Sweden 0.67*+ 0.59* * USA 0.26*+ 0.41* Average # counries wih pass hrough increase (# significan) 8 (2) 9 (1) # counries wih pass hrough increase (# significan) 16 (4) 15 (5) *, + Significanly differen from zero or one a 5 percen level. 11

13 Shor run Table 2: Rejecion of LCP or PCP for Impor Prices Enries in able show number of counries for which hypohesis is rejeced. Toal number of counries is 25 for all impors, 24 for disaggregaed producs. All Impors Food Energy Raw Maerials Manufac. Non- Manufac. Rejec = Rejec = Rejec =0 & = Average elasiciy Long run Rejec = Rejec = Rejec =0 & = Average elasiciy In our implemenaion of he Chow-ess, we compare elasiciies esimaed over he firs half of he sample, 1977 hrough 1989, wih hose from he full sample hrough The resuls from his spli sample approach (shown in he righmos columns of Table 1 and summarized in he boom wo rows of he able) ell a mixed sory on he direcion of change in pass-hrough across counries. Shor run exchange rae pass-hrough declined for 16 counries 4 cases wih saisically significan declines and increased in 8 counries. A similar paern appears in he long run elasiciies. Thus, while Chow ess sugges ha here has been a endency oward declines in exchange rae pass-hrough across OECD counries, hese ess also poin o only a limied number of cases where hese declines were saisically significan. Declining pass-hrough was no eviden in he aggregae impor prices of he Unied Saes. By conras, Japan regisered large declines in exchange rae pass hrough ino impor prices. Overall, he Chow ess (wih mid-poin breaks) significanly rejec srucural sabiliy for 6 counries of he 25 counries for pass-hrough coefficiens over he aggregae impor price series. For he second se of sabiliy analyses, we es for he presence of a srucural breaks in pass-hrough using he mehod proposed by Andrews (1993) and Andrews and Ploberger 12

14 (1994). These mehods es for he exisence of a srucural break poin in he saed relaionship a some unknown dae wihin he sample period. These ess have he advanage ha he researcher does no need o specify a priori he dae in which he srucural break akes place. However, hese ess are asympoic and heir power in our conex is quie limied by he number of observaions in our impor price series (generally around 100 quarers per series). Indeed, as summarized in he las row of Table 3, we can never rejec sabiliy of long run pass-hrough according o hese ess. While shor run pass-hrough sabiliy is also rejeced for 9 counries, i is difficul o assign he iming of insabiliy o a paricular break dae, suggesing ha he insabiliy is gradual raher han associaed wih a disinc poin in ime. The sample of 9 counries for which sabiliy is indicaed overlaps wih, bu is no idenical o, he Chow es insabiliy counries. Table 3: Pass-Through Parameer Sabiliy Enries in able show number of counries for which sabiliy hypohesis is rejeced. Toal number of counries is 25 for all impors, 24 for disaggregaed producs All Impors Food Energy Raw Maerials Non- Manufac. Manufac. Chow Tes Shor run insabiliy Long run insabiliy Hansen Tes Shor run insabiliy Long run insabiliy Nex, we consider he degree and sabiliy of exchange rae pass-hrough ino he prices of he five available sub-aggregaes of impor prices repored by he OECD: Food, Energy, Raw Maerials, Manufacuring Producs, and Non-manufacuring Producs. 16 As summarized in Table 2, mos indusries exhibi a sriking degree of parial pass-hrough. For all produc caegories wih he excepion of Energy, we rejec he hypohesis of zero exchange rae pass-hrough (LCP) for more han half of he counries. For Manufacuring and Food, we similarly rejec complee pass hrough (PCP). The evidence in suppor of 16 Appendix Table 1 provides hese esimaes, by counry. Anoher imporan issue wih respec o moneary policy is he pass-hrough comparison for final goods prices versus impored inermediae goods prices (Obsfeld 2000). Energy and Raw Maerials can be viewed as being closer o classificaion as impored inermediae goods han Food, Manufacuring, and Non-manufacuring Producs. 13

15 parial pass-hrough is sronges for Manufacuring impors, for which shor run pass-hrough differs significanly from boh zero and one in 19 ou of 24 counries. Food also exhibis parial pass-hrough in he shor run. Local currency pricing is ofen rejeced for Non- Manufacuring and Raw Maerials, bu rejecions of producer currency pricing are more mixed across counries. The sabiliy of pass-hrough ino disaggregaed impor prices appears more robus han he sabiliy ino he aggregae impor price series. This apparen sabiliy helps provide a deeper undersanding of he sources of flucuaions in pass-hrough ino aggregae impor prices. Indeed, he aggregae impor price series could poenially evolve over ime because of changes in he composiion of he impor bundles, raher han because of changes in he underlying pass-hrough elasiciies on componen producs. For he underlying classes of impors we formally es for he sabiliy of hese pass-hrough elasiciies by counry. As summarized in Table 3, we never rejec sabiliy of he disaggregaed pass-hrough coefficiens for more han 5 counries, and he number is closer o 2 or 3 in any produc caegory across 24 counries. 17 By conras, sabiliy is rejeced in 9 of he 25 cases for he aggregae impor price series. These resuls are an indicaion ha exchange rae pass-hrough raes for he sub-indices are more sable han he exchange rae pass-hrough for aggregaed impor prices. Finally, all of our ess showed ha Energy impors have he mos anomalous behavior among all he produc caegories, wih counry experiences varying considerably. For Energy impors, pass-hrough elasiciies calculaed using effecive exchange raes are noisy, bu cluser eiher around zero (rejeced in he shor run for only 8 of 24 counries) or around one (rejeced for 7 of 24 counries). Given he noise in he energy esimaes of exchange rae, and he anecdoal evidence ha energy markes are highly globally inegraed wih prices deermined in U.S. dollars, we proceeded o a furher examinaion of he Energy series. Specifically, we consider hree available disaggregaes of energy impor prices: Oil, Coking Coal, and Seam Coal. 18 Insead of using effecive exchange rae series, we examined pass-hrough of bilaeral local currency exchange raes agains he U.S. dollar. The resuling 17 Many of hese insances of produc caegory insabiliy are aribued o daa from New Zealand and Japan. Excluding hese wo counries, he number of counries for which here are rejecs in he disaggregaed daa ypically falls o 1 or See Appendix Table 3 for deailed resuls. The counries for which Oil impor price daa is used include: Ausralia, Ausria, Belgium, Canada, Germany, Denmark, Spain, France, U.K., Greece, Ialy, Japan, Neherlands, Norway, New Zealand, Porugal, and Sweden. We do no repor pass-hrough for he U.S. impor prices, since hese ess are for currencies vis-à-vis he U.S. dollar. 14

16 pass-hrough elasiciies were much more precisely esimaed for hese disaggregaed produc caegories. As repored in Appendix Tables 3A and 3B, bilaeral dollar movemens fully pass-hrough ino local currency Oil prices. Coking Coal and Seal Coal, known o be more heerogeneous producs because of heir sulfur conen and local sandards, exhibi more varied raes of pass-hrough across counries. Overall, we again find ha parial pass-hrough is a common phenomenon paricularly among heerogeneous producs. More homogeneous producs have more exreme pass-hrough values. 4. Exchange Raes and Impor Prices: A Macro or Micro Phenomenon? The previous secion demonsraed he prevalence of parial exchange rae pass hrough ino impor prices, and he large cross-counry and ime-series variaion in some elasiciies. In his secion we explore he empirical meris of alernaive hypoheses posed in recen debaes over he link beween macroeconomic variables and pass-hrough. Given our breadh of daa on aggregaed and disaggregaed impor prices for OECD counries, we also pose an alernaive explanaion for ime series changes in aggregae impor price pass-hrough. Specifically, we consider he degree o which changes in aggregae impor elasiciies are aribuable o movemens over ime in he composiion of OECD impors. A. Macro deerminans of pass-hrough. Taylor (2000) hypohesized ha he decline in average inflaion raes in he developed world has also resuled in a decline in he degree in which firms pass-hrough changes in coss ino prices for heir final goods. By his view, all else equal, lower inflaion leads o lower impor price pass-hrough. The relaionship beween more sable moneary policy and pass-hrough also occurs in recen heoreical work by Devereux and Engel (2001) and Bacchea and van Wincoop (2001) on opimal invoicing currency choice. If exporers se heir prices in he currency of he counry ha has he mos sable moneary policies, impor prices in local currency erms would be more sable in counries wih more sable moneary policy. All else equal, exchange rae pass-hrough would be higher for counries wih more volaile moneary policy. Anoher reason for macro variables o influence pass hrough is due o exporer compeiion for marke share. As discussed in Froo and Klemperer (1989), exchange rae pass-hrough may be lower when nominal exchange rae variabiliy is high and exporers o a counry ry o mainain local marke share. 15

17 Counry size may be anoher imporan facor in ranking pass-hrough elasiciies of counries. As iniially exposied by Dornbusch (1987), exchange rae pass-hrough may be higher if he exporers are large in number relaive o he presence of local compeiors. One approximaion o his poin is ha pass-hrough elasiciies migh be inversely relaed o counry real GDP. An alernaive approach would be o also consider measures of secorspecific openness for counries. We es for he imporance of hese alernaive hypoheses by running second sage regressions over he shor-run and long-run pass-hrough elasiciies of OECD counries. The second sage regression is given by γ = α + β + ε (8) i i i sr or lr x where x i is a vecor represening all he exogenous regressors: counry-specific average inflaion raes, money growh raes, exchange rae volailiy, and real GDP during he sample period. The bivariae and mulivariae cross-counry regressions use weighed leas squares regressions of shor and long run elasiciies. In his weighed leas squares mehod, where we use as weighs he inverse of he sandard error of he esimaed pass-hrough elasiciies, noisy esimaes receive less weigh in he second sage specificaions. The ime series variables used in consrucing he righ-hand-side macro variables are all measured quarerly over he sample period 1975:1 o 1999:4. These variables include: Money measured as he average annualized growh rae of he money supply (in logs); Inflaion is average annualized inflaion rae, based on consumer price indices (in logs). Exvol is he average of he quarerly squared changes in he nominal exchange rae; GDP: is he nominal value in naional currency deflaed using he CPI deflaor and convered ino U.S. dollar a he average 1996 nominal exchange rae. The resuls of he second sage panel regressions are presened in Table 4. These cross-counry resuls, which do no have a ime series componen, show ha counry-specific raes of exchange rae pass-hrough ino impor prices are no significanly correlaed wih inflaion or money growh. However, shor-run elasiciies are correlaed wih nominal exchange rae volailiy: counries wih more nominal volailiy have higher pass-hrough raes. The resul ha lower nominal volailiy is associaed wih lower pass-hrough is consisen wih he main heoreical resuls of Devereux and Engel (2001) and Bacchea and vanwincoop (2001). The role of counry size, however, is insignifican in he rankings of pass-hrough raes across counries. Despie he observaion ha U.S. pass-hrough raes are 16

18 quie low, across he OECD here is no sysemaic relaionship beween pass-hrough and a counry real GDP. Some large counries have high pass-hrough (Japan) while some small counries have low pass-hrough (Czech Republic). Table 4 Deerminans Pass-Through Elasiciies: Cross Counry Panel A. Shor Run Elasiciies of Aggregae Impor Prices Consan 0.536** (0.237) 0.640** (0.145) 0.571*** (0.042) 0.656*** (0.180) 0.683** (0.333) Money (0.237) (0.167) Inflaion (0.074) * (0.135) ExVol 4.737*** (1.686) 5.875*** (1.828) Real GDP (0.030) (0.030) AdjR Table 4 B. Long Run Elasiciies of Aggregae Impor Prices Consan 0.737** (0.277) 0.912*** (0.171) 0.744*** (0.054) 0.770*** (0.208) (0.488) Money (0.113) (0.229) Inflaion (0.086) ** (0.181) ExVol (2.041) (2.220) Real GDP (0.034) (0.040) AdjR Nobs ***, **, * indicae saisical significance a he 1, 5 and 10 percen levels, accordingly. All regressions are weighed leas squares. While hese cross-counry resuls are especially ineresing for currency invoicing hypoheses, he ess conduced are no he mos appropriae ones for addressing he ype of pass-hrough endogeneiy exposied by Taylor (2000). For saisfying he laer objecive, we absrac from oher counry-specific deerminans of pass-hrough raes and ask wheher changes o a counry s pass-hrough elasiciies are sysemaically associaed wih changes in macroeconomic performance. The changes approach is paricularly relevan since he macroeconomic indicaors inroduced in equaion (8) have moved subsanially during he 17

19 pas hree decades for many OECD counries. For example, inflaion raes and money growh were subsanially larger during he firs par of he sample han during he second. To capure he observaion ha he average behavior of some of hese exogenous variables over he full period is no represenaive of behavior over shorer inervals, we spli he full sample period ino four subperiods: 1975:1 o 1980:4, 1981:1 o 1986:4, 1987:1 o 1992:4, and 1993:1 o 1999:4. For each subperiod, we run a firs-sage regression of he ype shown by equaion (7) and consequenly generae four esimaes of he shor and long-run pass-hrough elasiciies of aggregaed impor prices for each counry. We hen apply a imeseries panel version of equaion (8) as he second sage specificaion. More precisely, we regress he esimaed elasiciies (4 per counry, 25 counries) agains he average value of he macroeconomic variables for each counry during he respecive ime periods. 19 We again use a weighed leas squares procedure o reduce he imporance of he noisier parameer esimaes in driving overall conclusions (he weighs are he inverse of he esimaed sandard error each pass-hrough). Wihin his ime-series panel approach, he second sage regressions also include counry and ime dummies in order o accoun for oher counry and period-specific fixed effecs ha are no capured for by he exogenous righ-hand-side variables. The ime-series panel resuls presened in Table 5 show he role of changes in macroeconomic deerminans in driving changes in he shor run and long run pass-hrough elasiciies of OECD counries. Consisen wih Taylor s (2000) argumens, shor run passhrough is lower when a counry achieves lower inflaion, less money growh, or less exchange rae variabiliy. Lower and more sable moneary condiions induce producers o pass on a smaller percenage of cos shocks ino final goods prices. While money growh and exchange rae volailiy do no appear o be saisically imporan in hese mulivariae regressions, his is mainly due o heir high correlaion wih inflaion, which is picking up he saisical conribuion of boh erms. Despie he join saisical significance of hese macroeconomic variables for he shor-run specificaion, hey accoun for a negligible amoun of he variaion over ime in pass-hrough elasiciies across counries. The order of magniude of inflaion changes on pass-hrough changes is low, especially in he conex of inflaion ranges observed wihin he OECD: a one percenage poin increase in he average inflaion rae for a counry is associaed wih a increase in pass-hrough. Indeed, F-ess show ha hese macro 18

20 variables have no explanaory power for long-run pass hrough raes across our OECD counry sample. Table 5 Macroeconomic Deerminans of Pass-Through: Time Series Panel Regressions Shor-Run Pass-Through (Levels) Long-Run Pass-Through (Levels) Time dummies Counry dummies Money (0.105) (0.175) Inflaion 0.231** (0.103) 0.229** (0.101) 0.335* (0.165) 0.322* (0.162) Exchange rae volailiy (37.97) (36.70) (58.29) (53.25) Real GDP (0.021) (0.021) (0.036) (0.036) Adj. R Adj. R2 from specificaion wih only Macro variables # observaions ***, **, * indicae saisical significance a he 1, 5 and 10 percen levels, accordingly. All regressions are weighed leas squares. B. The Role of he Composiion of Trade. An alernaive explanaion for changes in exchange rae pass-hrough ino aggregae impor prices may be he changes ha have occurred in he composiion of counry impors. Composiion shifs, operaing over passhrough elasiciies ha differ across ypes of impors, could deliver changes in he passhrough elasiciies on aggregae impor prices. If a counry shifs he conen of is rade from indusries wih high pass-hrough elasiciies ino indusries wih lower elasiciies, he counry s aggregae impor pass-hrough elasiciies will decline. Conversely, a shif o higher pass-hrough producs would raise he overall pass-hrough elasiciy of aggregaed impor prices. Wha is he empirical evidence on he changing composiion of rade wihin he OECD? A decomposiion of impors ino he five produc caegories shows ha composiion 19 The GDP variable reflecs he 1996 U.S. dollar value of each counry s GDP in 1978, 1984, 1990 and

21 changes have been subsanial. 20 The main force a work has been a remendous rise in he relaive imporance of manufacuring impors, along wih a reducion in he relaive imporance of energy. In 1980 manufacuring impors comprised more ha 50 percen of he overall (merchandise) impor bill for mos counries (Appendix Table 4). The clear excepions were counries heavily relian on impored energy, noably Japan, followed by Ialy and France. Japan also sood ou among OECD counries for he relaively large share of raw maerials in is impors. However, due o lower energy prices, changes in energy policies, and a dramaic growh of manufacuring rade, by he 1990s here was a sriking cross-counry shif in he composiion of impors. By 1992 manufacured producs became more han 70 percen of he impors of many OECD counries, and ofen closer o 80 percen of he impor bill. For France, manufacured producs grew from 45 o 79 percen of impors. A he same ime hese counries experienced a clear decline in he share of energy producs in oal impors, as illusraed in Figure 1, and an almos idenical increase in he share of manufacuring Producs. Since produc caegories have disinc (and relaively sable) passhrough raes, his shif in he relaive imporance of energy and manufacuring producs in impor volumes will be shown o accoun for a significan fracion of he changes observed in he pass-hrough elasiciies ino aggregaed impor prices across OECD counries. 20 These caegories are defined by he availabiliy of cross-counry daa on impor prices. 20

22 Figure 1 Decline of Energy Share in Impors, 1992 vs Energy as a percen of oal counry impors in 1980 versus France Ialy Japan U.S Canada Ausria Belgium Ausralia Denmark Germany Finland UK Ireland Neherlands Norway Sweden 5 0 By OECD Counry To empirically deermine he imporance of impor composiion for pass-hrough raes, we inroduce a rade composiion effec direcly ino he ime-series panel regressions. Specifically, for each counry and ime period we consruc an impued aggregae passhrough elasiciy which capures he changes in a counry s aggregae pass-hrough elasiciies specifically aribuable exclusively o changes in is composiion of impors. The consruc uses he ime-invarian (full sample period) esimaes of pass-hrough elasiciies for each of he five indusry groupings for each counry. The impued elasiciy is consruced by varying over he ime he weighs of each ype of impor in each counry s oal impor bundle. We use as weighs he impor share values a 1980, 1986, 1992, and The impued measure racks reasonably well he paern of pass-hrough declines observed in he acual pass-hrough esimaes for he sample of counries for which comparisons are possible. The impued measure generaes declines for 10 of he 14 cases where declines were observed in he acual daa. The impued measure generaes passhrough increases in 5 of he 7 cases where increased pass-hrough was observed in he acual daa. 21 Availabiliy of he appropriae disaggregaed impor daa reduced he number of counries included. 21

23 The main reason for his decline in he aggregae impor price elasiciy is due o he decline in he relaive weigh in overall impors of energy and raw maerials. These are he wo producs for which he impor price elasiciies were ofen highes. According o his calculaion, he aggregae pass-hrough elasiciy for he Unied Saes would have declined from 0.37 o 0.25 beween 1980 and 1998 solely due o he change in he produc composiion of impors. For Ialy, he decline would have been far more dramaic, from 0.87 o C. Micro v. Macro Deerminans of Exchange Rae Pass-Through. As a final exercise, we run a horse race o saisically conras he explanaory power of he micro versus macro variables for exchange rae pass-hrough movemens over ime and across counries. For mos counries we have pass-hrough esimaes a four inervals. We have impued elasiciies (from he disaggregaed impor daa) for he 21 counries ha had adequae rade share decomposiions for our purposes. This composiion effec is inerpreed as a microeconomic force behind changes in aggregae exchange rae pass-hrough. The exended second-sage regression akes he form: γ = β ln money + β lninflaion + β ln exchvol + β lngdp j j j j sr or lr β lnimpued + α + α + ν 5 j i j (9) where counry and ime dummies are included, and weighed leas squares esimaion is again applied. The resuls are repored in Table 6. Common ime dummies, macro variables and impued rade shares explain abou 20 percen of he observed differences over ime in he shor-run pass-hrough elasiciies of counries. The hypohesis of he join insignificance of he macro variables canno be rejeced a he one percen level. Almos all of he explanaory power of he regressions comes from he impued rade elasiciy variables, even hough he composiion argumens are made wih only he coarsely disaggregaed series ha are available in he impor price daa. Trade composiion effecs is he clearly dominan explanaion for movemens over ime in he shor-run and long-run sensiiviy of impor prices o exchange raes. 22

24 Table 6 Macro versus Micro Deerminans of Pass-Through: Time Series Panels Shor-Run Pass-Through (log Levels) Long-Run Pass-Through (log Levels) Time dummies Counry dummies Money (0.125) (0.202) Inflaion (0.147) (0.148) (0.233) (0.237) Exchange rae volailiy (x100) (3.203) (3.236) (4.915) (0.499) Trade Impued Elasiciy 2.505** (1.115) 2.549** (1.126) 1.643*** (0.848) 1.590*** (0.861) Real GDP (0.022) (0.022) (0.040) (0.040) Adj. R Adj. R2 from specificaion w/only Macro variables Adj.R2 from rade impued elasiciy only # obs ***, **, * indicae saisical significance a he 1, 5 and 10 percen levels, accordingly. All regressions are weighed leas squares. 5. Conclusions In his paper we have provided cross-counry, ime-series, and indusry-specific evidence on he pass-hrough of exchange raes ino impor prices across a large sample of OECD counries. As a cross-counry average, impor prices in local currencies reflec 60 percen of exchange rae flucuaions in he shor run, and nearly 80 percen over he longrun. By conras, exchange rae pass-hrough ino U.S. impor prices is 25 percen in he shor run and 40 percen over he long run. For he OECD as a whole, parial pass-hrough is overwhelmingly he bes descripion of impor price responsiveness shorly afer an exchange rae movemen. In he longer run, pass-hrough elasiciies are closer o one, alhough complee pass-hrough or producer currency pricing is sill rejeced for many counries. Macroeconomic variables play a significan bu limied role in explaining cross-counry differences in levels of pass-hrough elasiciies. Mos noably, pass-hrough ino impor prices is lower for counries wih low average inflaion and low exchange rae variabiliy. While here is evidence ha pass-hrough raes have been declining over ime in some counries, his paern of pass-hrough decline has no been a common feaure of all OECD counries. Shor-run exchange rae pass-hrough elasiciies rise wih price inflaion (or 23