Academic journal article New England Economic Review

Exchange Rates and the Prices of Manufacturing Products Imported into the United States

Academic journal article New England Economic Review

Exchange Rates and the Prices of Manufacturing Products Imported into the United States

Article excerpt

Exchange rate fluctuations remain remarkably large, despite the steady decline in the volatility of the trade-weighted dollar since the late 1980s. Yet large fluctuations in the value of the dollar do not translate into similarly large swings in the domestic production of traded goods relative to foreign. The reason lies mainly in the fact that the prices of imported goods do not usually respond one-for-one to changes m the exchange rate. The extent and pervasiveness of such a phenomenon, often labeled as incomplete "pass-through" of exchange rates to import prices, has long been debated in academic and policy circles.

From a macroeconomic standpoint, knowing how much of a change in the exchange rate is passed through to import prices is important for assessing the effects of changes in currency value on both the balance of payments and domestic inflation. Of particular interest is whether the devaluation of a nation's currency would improve its external balance. From an imports perspective, this amounts to asking what portion of the devaluation would be passed through to local-currency import prices. Other things equal, the lower the degree of pass-through, the larger the currency depreciation needed to achieve a given reduction in the quantity of imports.

A related question concerns the effect of exchange rate changes on overall domestic inflation. Some have argued that low import prices were the main reason behind the low inflation rates that characterized the U.S. expansion through the late 1990s. (1) According to this view, import prices helped to keep inflation low not only via their direct effect on overall inflation, but also indirectly by putting pressure on domestic firms to maintain stable prices. While contentious, this argument highlights the importance of knowing how the prices of imported goods are set and specifically how these prices are affected by fluctuations in the exchange rate.

A few studies have conveyed the notion that passthrough to import prices has been declining in the recent past, across both industrialized and developing countries. Most of this work relies on event studies and examines the impact of exchange rate changes on overall inflation. (2) The finding that the response of domestic inflation to exchange rate changes was more muted in recent episodes than in earlier periods is consistent with declines in pass-through into import prices. Yet, despite the abundance of empirical research on the relationship between exchange rates and import prices, (3) there is little systematic evidence on the time-series dimension of pass-through that encompasses the most recent years.

In this article, we provide some updated estimates of exchange rate pass-through to U.S. import prices that span the period 1981 to 1999. We use a cross-section of manufacturing industries at the 2-, 3-, and 4-digit Standard Industry Classification (SIC) level. These cover almost 75 percent of non-energy commodities imported into the United States. As in previous studies, we find a considerable degree of variation in pass-through across different industries. In addition, we document a decline in pass-through for the majority of industries in the most recent decade. For the industries in our sample, passthrough was 0.50 on average in the 1980s and dropped to an average of about 0.25 in the 1990s. This means that, other things equal, while in the 1980s a 1 percent dollar depreciation would translate into a 0.50 percent increase in import prices, in the 1990s the increase was only 0.25 percent. As with other studies, we find that it is difficult to relate the change in pass-through to macroeconomic outcomes suc h as the lower inflation rates achieved in many countries.

The rest of the article proceeds as follows. Section I provides a review of the microeconomic underpinnings of exchange rate pass-through. Section II describes the empirical framework used to estimate pass-through, while Section III describes the data used in this study. …

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