Academic journal article Journal of Money, Credit & Banking

Exchange Rate Pass-Through in a Competitive Model of Pricing-to-Market

Academic journal article Journal of Money, Credit & Banking

Exchange Rate Pass-Through in a Competitive Model of Pricing-to-Market

Article excerpt

WHY ARE THE movements of relative costs brought about by exchange rate fluctuations passed through to consumers only partially?

This paper develops a model of pricing-to-market under perfect competition and flexible prices. We build on the Mussa and Rosen (1978) model of quality pricing. Exporters sell goods of different qualities to consumers who have heterogeneous preferences for quality. We depart from the work of Mussa and Rosen in two important dimensions. First, we consider a perfectly competitive setting, as opposed to their original monopoly setting. Second, we introduce decreasing returns to scale at the firm level. In the resulting equilibrium, higher quality goods are matched with higher valuation consumers. The price schedule relating good quality to market price depends on the valuations of consumers who are matched with these goods. Prices are higher when the valuations of consumers in the market are higher.

We next analyze how our model can account for incomplete pass-through of cost shocks into consumer prices. The main insight of the model is that pass-through can be incomplete and heterogeneous across different goods even within a narrowly defined competitive industry. The crucial ingredient of our model is the heterogeneity of consumers: all consumers value quality, but they do so at different rates. In the absence of this heterogeneity in valuations, relative good prices are fixed by the representative consumer's valuation for quality, leading in equilibrium to equal pass-through rates across all goods in the industry. Relative prices in our model are determined by differences in quality and by differences in the valuations the respective qualities are matched with. Because the equilibrium matching of qualities and valuations responds to cost changes, pass-through rates differ across different goods.

We consider a purely real model of international price setting. Exchange rate shocks are assumed to be real productivity shocks so that there is no price stickiness, hence no money illusion, and no role for monetary policy. We derive three predictions for the rate of cost pass-through.

First, exchange rate shocks are only partially passed through to consumers. When an exporting country is hit by an appreciation of the real exchange rate, exporting firms scale down their exports. The relative scarcity of goods forces the lowest valuation consumers out of the market. As a consequence, exporters are matched with higher valuation consumers, thereby leading to higher prices. In equilibrium, only a part of the cost shock is passed through to consumers.

Second, we predict that there is more pass-through for low-quality goods than for high-quality goods. This prediction relies on a subtle argument. After an appreciation of the exporter's exchange rate, two forces drive up prices. The exit of low-quality firms shrinks the total supply of goods and forces the lowest valuation consumers out of the market. The average valuation of the remaining consumers increases and prices increase. In addition, all firms scale down their production, which shrinks the total supply of goods and drives up all prices. The relative strength of the first effect is larger for lower quality goods. As the set of exporters changes in response to exchange rate shocks, prices move almost one for one with the exchange rate for low-quality exporters, (1) The price of higher quality goods, on the other hand, depends on the overall tightness of the market, which determines which consumer is matched with which good. In the limit, infinitely high-quality goods prices are, in relative terms, not at all affected by the exit of low quality firms. Their price increases only because all firms scale down their production. The pass-through of exchange rate shocks is thus higher for low-quality goods than for high-quality goods.

Third, we predict that in response to an exchange rate appreciation, the composition of exports shifts toward high-quality, high-price goods. …

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