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Slow Pass-through Around the World: A New Import for Developing Countries?

Abstract

Developing countries traditionally experience pass-through of exchange rate changes that is greater and more rapid than high-income countries experience. This is true equally of the determination of prices of imported goods, prices of local competitors’ products, and the general CPI. But developing countries in the 1990s experienced a rapid downward trend in the degree of pass-through and speed of adjustment, more so than did high-income countries. As a consequence, slow and incomplete pass-through is no longer exclusively a luxury of industrial countries. Using a new data set—prices of eight narrowly defined brand commodities, observed in 76 countries—we find empirical support for some of the factors that have been hypothesized in the literature, but not for others. Significant determinants of the pass-through coefficient include per capita incomes, bilateral distance, tariffs, country size, wages, long-term inflation, and long-term exchange rate variability. Some of these factors changed during the 1990s. Part (and only part) of the downward trend in pass-through to imported goods prices, and in turn to competitors’ prices and the CPI, can be explained by changes in the monetary environment—including a fall in long-term inflation. Real wages work to reduce pass-through to competitors’ prices and the CPI, confirming the hypothesized role of distribution and retail costs in pricing to market. Rising distribution costs, due perhaps to the Balassa-Samuelson-Baumol effect, could contribute to the decline in the pass-through coefficient in some developing countries.

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Notes

  1. Taylor (2000) proposed that a decline in pass-through of exchange rate changes into the CPI in the 1990s was due to a lower inflationary environment, and looked at US data. Gagnon and Ihrig (2004) extended this claim to a sample of 11 industrialized countries, finding that the standard deviation of inflation explains the coefficient better than does the average inflation rate.

  2. The BIS (2002, p. 92) is among those attributing the low pass-through to the CPI of recent large devaluations in developing countries to a decline in long-run inflation. But Burstein et al. (2002) attribute the low observed pass-through in general price indices to the disappearance from consumption of newly expensive import goods, and their replacement in the indices by inferior local substitutes.

  3. Aw (1993) examines exports from Taiwan to four countries of footwear, but they are heavily affected by quotas. Also, like Maloney’s (1994) study of Chile, the data are for an earlier period. Parsley (2002) examines exports from Hong Kong, and finds little pricing to market.

  4. Among those who emphasize the importance in incomplete pass-through of local distribution costs consisting of nontraded inputs are Burstein et al. (2002), Burstein et al. (2003b), Campa and Goldberg (2004), Corsetti and Dedola (2002), Frankel (1984), and many others. Parsley and Wei (2003) offer some detailed evidence that the law of one price holds much better for traded inputs than for the product sold to consumers. They seek to reaffirm the conventional wisdom that the failure of PPP can be partly explained by non-traded goods and services, by refuting the Engel (1999) challenge, that the explanation lies solely in failures of the law of one price among traded goods. Burstein et al. (2003a) is another challenge to Engel, this time for four large-devaluation episodes.

  5. In addition to Dornbusch (1987) and Krugman (1987), the price discrimination theory is featured in Marston (1990), Gagnon and Knetter (1995), Yang (1997), Corsetti and Dedola (2002), among many others.

  6. Kasa (1992) shows how adjustment costs can generate incomplete pass-through in the short-run. Ghosh and Wolf (1995) study changes in the local price of the Economist magazine in various countries in response to exchange rate changes, and argue that the timing supports the sticky price view, arising from menu costs, better than the pricing to market view, arising from price discrimination. Devereux and Yetman (2002) apply a menu-cost model to the endogenous determination of pass-through. Burstein et al. (2003a) includes another sticky-price model.

  7. In the Cournot oligopoly model of Dornbusch (1987), for example, the extent of pass-through is determined by the proportion of foreign firms present in the domestic marketplace, relative to domestic firms.

  8. Imbs et al. (2002) claim that problems of aggregation are the source of estimates of apparently slow convergence to PPP. Chen and Engel (2004) reject their argument.

  9. Kreinen (1977) and Magee (1973).

  10. There are also other reasons why the literature on incomplete pass-through took off in the late 1980s: it provided an application for some tools of game theory that had then been newly imported into international trade theory from industrial organization; it provided an application for new mathematical techniques of option-pricing with continuous-time stochastic processes (e.g., Dixit, Krugman, Baldwin); the micro price data needed for empirical work became available (e.g., Knetter 1989, 1993); the partial equilibrium exercise of taking exchange rate movements as given became more interesting when models to explain the exchange rate had clearly failed; and slow pass-through into the US market—particularly in the case of automobiles and other exports from long-horizon Japanese producers (e.g., Marston 1990; Froot and Klemperer 1989; Feenstra 1989; Parsley 1993; Gagnon and Knetter 1995; Ohno 1989)—seemed to help explain the slow reaction of the US trade balance to the 1985–97 depreciation of the dollar (Mann 1986).

  11. The models of Devereux and Engel (2002) and Devereux et al. (2002) show how the absence of pass-through reduces the real effects of exchange rate variation.

  12. See Goldberg and Knetter (1997) for a survey.

  13. With full mark-up pricing, pass-through may be complete even though the Law of One Price fails. The two criteria differ. Failure of complete pass-through will invalidate even relative Purchasing Power Parity, while failure of the Law of One Price need invalidate only Absolute PPP.

  14. We would expect pass-through to prices of other local goods to be lower, however. In an optimal-pricing model where imports are intermediate products, Bacchetta and Van Wincoop (2002) show pass-through to consumer goods prices to be low if there is local competition.

  15. Indeed, in the thoery of Devereux and Yetman (2002), exchange rate variability, like price instability, should raise the pass-through coefficient. But they sometimes find the opposite, empirically.

  16. Ho and McCauley (2003).

  17. French VSOP Cognac is an exception to this stringent brand-specific rule; however after checking with the EIU we were told that the Cognac brands were, in fact, specified as Remy Martin, or Courvoisier; however another brand would be surveyed if these were not available, as long as it was VSOP, and not VS, XO, or 3-star. Moreover, our empirical findings also apply to this more general category.

  18. All Appendix Tables referred to in what follows are available in the working paper version, Harvard Kennedy School Faculty Research Working Paper Series No. 05-016, 2005.

  19. It is possible that there is an element of endogeneity to the export prices—that a depreciation of the Moroccan currency against the French franc or euro shows up partly as a decline in the price of the export product in France, not just as an increase in the price in Morocco. But as almost all the exporters are large countries, we guess that this effect may be small.

  20. Indeed, the decline in the average inflation rate in industrial countries has been steady over three decades: from 12% in the second half of the 1970s to 2% in the second half of the 1990s. The average inflation rate among developing countries has moved less monotonically, but also has declined substantially more recently (from 25% in the second half of the 1970s to 13% in the second half of the 1990s). Tytell and Wei (2003).

  21. Knetter (1993) and Campa and Goldberg (2002). Otani et al. (2003) similarly conclude that composition cannot be the entire explanation for the decline of pass-through, for the case of the Japanese market.

  22. For Appendix Tables 1 and 5, see the webpage in the working paper version, Harvard Kennedy School RWP No. 05-016, 2005.

  23. That the pass-through coefficient is similar suggests higher substitution than one might expect.

  24. Without country dummies (Appendix Table 6), the unconditional pass-through coefficient is higher (.56), with an equally strong downward trend. Most of the results are as before. Richer countries clearly have a lower pass-through coefficient [but appear to have a faster speed]. Tariffs, wages, size and long-term inflation have strong effects on the level of pass-through. Size works strongly to slow down the speed of adjustment. Exchange rate variability again has the unexpected significant effect of increasing the speed. [Distance has a puzzling positive coefficient. The US dummy appears very significant and of the unexpected sign; but this should probably be discounted because it is estimated from only three non-U.S. export goods—cointreau, cognac and vermouth—all three of which unfortunately have the same domestic competitor good, beer.]

  25. The results are similar when the country dummies are omitted (Appendix Table 7). The most notable difference is that higher wages are now seen to slow down the speed of adjustment significantly.

  26. Charles Engel suggested this line of exploration to us.

  27. We could allow for correlation of errors across commodities. In Appendices a1-a8, b1-b8, and c1-c8, we report results we have obtained for individual commodities. They show a lot of variation (which we attribute to garden-variety estimation error). The results reported here were for the eight commodities pooled together, though with commodity-specific dummies.

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Acknowledgement

The authors would like to thank Charles Engel, Linda Goldberg, and participants at seminars at the IMF and Federal Reserve Board for comments.

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Correspondence to Jeffrey Frankel.

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Frankel, J., Parsley, D. & Wei, SJ. Slow Pass-through Around the World: A New Import for Developing Countries?. Open Econ Rev 23, 213–251 (2012). https://doi.org/10.1007/s11079-011-9210-8

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Keywords

  • Exchange rate
  • Import
  • Law of one price
  • Pass-through
  • Price
  • Pricing to market
  • Purchasing power parity

JEL Classification

  • F4