|
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. This prediction is due to the endogenous selection of exporters: in the presence of a fixed cost to enter foreign markets, only the highest quality firms are able to export. When hit by a negative exchange rate shock, the lowest quality firms--which charge the lowest prices--pull out of the export market. The exit of low-quality, low-price exporters has an effect not only on individual prices but also on aggregate prices. As low-quality, low-price exporters pull out, the composition of exports shifts toward high-price goods. Since the composition of exports shifts toward high-quality, high-price goods, aggregate price indices tend to overestimate the actual extent of pass-through for individual goods.
We next test these predictions using highly disaggregated price and quantity U.S. import data. First, we confirm the widely documented finding that exchange rate shocks are only partially passed through into export prices. This finding holds not only at the aggregate level, as it is commonly described, but also at the highest level of disaggregation allowed by the data. Second, we find no statistically significant evidence that higher quality goods, proxied by higher unit value goods, are characterized by higher pass-through rates. Third, while we find that the composition of exports shifts toward higher quality goods in response to an exchange rate appreciation, this result is not statistically significant.
Our approach is motivated by recent findings on exchange rate pass-through. Campa and Goldberg (2005) give an up-to-date review of the evidence on incomplete pass-through. Even though there is almost full pass-through of exchange rate shocks for prices at the dock, there is much more limited pass-through for consumer prices. The order of magnitude is 40% in the short run and 60% in the long run. The empirical literature has stressed the importance of distribution margins in explaining this fact. Burstein, Neves, and Rebelo (2003), Burstein, Eichenbaum, and Rebelo (2005), and Campa and Goldberg (2006) argue that nontradable inputs such as distribution costs play a key role. Burstein, Neves, and Rebelo note that for a typical consumption good in the U.S., distribution margins account for more than 40% of the final price. Finally, and most related to our model, Campa and Goldberg note that distribution margins do not remain stable during real exchange rate fluctuations. A 1% real exchange rate depreciation leads to a 0.47% reduction in distribution margins. This response of local distribution margins to the exchange rate has also been documented for the case of the beer industry by Hellerstein (2008).
To capture these facts, we introduce a two-tiered production function similar to Bacchetta and van Wincoop (2003). While transportation costs are linear, we assume that the production capacity of a firm is fixed so that supply to any foreign market is subject to decreasing returns to scale. One possible interpretation of this fixed capacity is that finns have a fixed distribution network. Under this assumption, our model gives rise to incomplete pass-through of exchange rate shocks despite full pass-through at the dock, and to fluctuations in the distribution margin in response to exchange rate movements. One important point is that in our model, all costs are paid in the exporters' currency, not in the local currency. We make this assumption to stress the fact that decreasing returns to scale matter, even if no part of this cost is paid in the importer's currency. If part of the distribution costs were paid in foreign currency, our results would be reinforced.
We point out the potential importance of composition effects in estimating exchange rate pass-through. Burstein, Eichenbaum, and Rebelo (2005) suggest one specific composition effect, flight from quality. They point out that following a large devaluation, consumers stop buying high-quality goods. Our predictions regarding this flight from quality are ambiguous. Indeed, following a devaluation, we predict that overall, since fewer quality goods are imported, many consumers switch from quality goods to generic goods produced at home. However, the consumers who still buy quality-differentiated goods will typically buy higher quality goods at a higher price. (2)
The importance of heterogeneity in product quality for export selection has been emphasized by Baldwin and Harrigan (2007). Building on the empirical observations of Schott (2004), Hummels and Klenow (2005), Hallak (2006), and Hallak and Schott (2008), the authors argue that selection into the export sector occurs along the dimension of product quality rather than physical productivity. This insight has been extended by Johnson (2008), who predicts that firms with heterogeneous productivity in equilibrium produce output of heterogeneous quality.
In this paper, we explore the implications of export selection along the dimension of product quality for exchange rate pass-through. In this respect, the predictions of our model are similar to Verhoogen (2008), who analyzes the effect of exchange rate fluctuations on wage inequality in an economy where high quality workers are employed by firms producing high quality exports. Rather than analyzing the relationship between product quality and relative wages, we analyze the relationship between quality and relative pass-through rates.
Despite the growing literature on measuring the quality of exports, there is to our knowledge little evidence on the degree of exchange rate pass-through for exports of different qualities. Gagnon and Knetter (1995) study the exchange rate pass-through for car exports from three main automobiles exporters and find that pass-through rates differ across cars of different classes.
In addition to examining the quality dimension of cost pass-through, we also highlight that incomplete pass-through can arise under perfect competition and flexible prices. The existing theoretical literature on exchange rate pass-through and pricing-to-market has so far relied on two alternative assumptions: either price stickiness or imperfect competition.
For example, Betts and Devreux (1996), Taylor (2001), and Bacchetta and van Wincoop (2003) show that pass-through is incomplete and staggered when prices are sticky. Gopinath...
|
