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Open Economies Review

, Volume 24, Issue 5, pp 853–879 | Cite as

Exchange Rate Pass-through in a Small Open Economy: the Importance of the Distribution Sector

  • Pål BougEmail author
  • Ådne Cappelen
  • Torbjørn Eika
Research Article

Abstract

The degree of exchange rate pass-through to domestic goods prices has important implications for monetary policy in small open economies with floating exchange rates. Evidence indicates that pass-through is faster to import prices than to consumer prices. Price setting behaviour in the distribution sector is suggested as one important explanation. If distribution costs and trade margins are important price components of imported consumer goods, adjustment of import prices and consumer prices to exchange rate movements may differ. We present evidence on these issues for Norway by estimating a cointegrated VAR model for the pricing behaviour in the distribution sector, paying particular attention to exchange rate channels likely to operate through trade margins. Embedding this model into a large scale macroeconometric model of the Norwegian economy, which inter alia includes the pricing-to-market hypothesis and price-wage and wage-wage spirals between industries, we find exchange rate pass-through to be quite rapid to import prices and fairly slow to consumer prices. We show the importance of the pricing behaviour in the distribution sector in that trade margins act as cushions to exchange rate fluctuations, thereby delaying pass-through significantly to consumer prices. A forecasting exercise demonstrates that exchange rate pass-through to trade margins has not changed in the wake of the financial crises and the switch to inflation targeting. We also find significant inflationary effects of exchange rate changes even in the short run, an insight important for inflation targeting central banks.

Keywords

Exchange rate pass-through Pricing behaviour The distribution sector Econometric modelling and macroeconomic analysis 

JEL classifications

C51 C52 E31 F31 

Notes

Acknowledgements

The authors thank an anonymous referee, Roger Bjørnstad, Peter Broer, Torstein Bye, Bjørn Naug, Ragnar Nymoen, Terje Skjerpen, Aris Spanos and participants at the 27th Annual Congress of the European Economic Association in Malaga 2012 for useful comments and suggestions. The econometric modelling of trade margins was performed using OxMetrics 6, cf. Doornik and Hendry (2009). Data underlying the econometric modelling of trade margins and test results referred to in the text are available from the authors upon request. The usual disclaimers apply.

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Copyright information

© Springer Science+Business Media New York 2013

Authors and Affiliations

  1. 1.Statistics Norway, Research DepartmentOsloNorway

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