Exchange Rate Pass Through : A Theoretical Perspective

Introduction

In the theory of exchange, two agents exchange goods and/or

services under the condition that both parties gain through the

operation of exchange. In a closed economy set up one agent can

procure commodity and/or services in exchange for money, which is

a legal tender, and hence acceptable to all. Money is the liability of

the central bank of the country, the issuer of the currency. As a

legal tender, so long as it can be converted into alternative assets, it

is a universal medium of exchange.

One standard assumption behind the universal acceptance of the

domestic legal tender is that the issuer of the currency, i.e. the

central bank of the country, will remain committed to maintain

stability of the intrinsic value of the currency. In an extreme

situation when this assumption does not hold or people lose

confidence in the sincerity of the central bank; people may not like

to accept the currency.

Money as a sovereign legal tender carries the implication that the

government will have the backing behind the currency. In many

countries the currency also carries the prestige of the ruling

authority. The potential implication is that the currency is not

acceptable beyond the political boundaries.

In an open economy framework economic agents of two different

countries exchange commodities and/or services. Thus the General

Motors in the USA can procure different components of cars from

Hindustan Motors of India. In such international transaction there

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should be a system developed enough for the conduct of such

international payments system.

The Bretton Woods System: 1944-1968

Whatever the world coordination system had been existing before

World War II under the agencies of the United Nations collapsed

during the war. At the end of the war, the leaders of the victorious

countries felt the urgent need for the establishment of world

institutions to take care of the international payments system,

which are vital for world trade and commerce. The thinking of the

victorious western nations at that time was dominated by two

preoccupations. First, there was urgency in the reconstruction of

the economies of Europe and Japan. Second, the countries were

eager to prevent a return to the competitive devaluations and

protectionism that prevailed in the 1930s. So at Bretton Woods,

New Hampshire, an agreement was signed in 1944 and two

institutions were born: the International Monetary Fund (IMF) and

the International Bank for Reconstruction and Development (IBRD).

From the name of the place, the agreement was named as Bretton

Woods System.

The objectives of the International Monetary Fund have been to

maintain a fixed exchange rate system in the initial period and also

to work as the central bank to the central banks of the member

countries. In this the member countries undertook two major

commitments: (i) to maintain convertibility, and (ii) to preserve a

fixed exchange rate. For the latter the member countries were

advised to follow prudent monetary and fiscal policies so that

monetary equilibrium in the domestic market was not disturbed.

Convertibility of the currency became more a pious intention than a

realistic objective as except the USA none of the member countries

was willing to allow free movement of capital in the initial period.

Even some years after 1958, the major European currencies offered

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only currency offered only current account convertibility. That

means, these currencies were freely usable for financing

international trade, but were subject to severe restrictions where

the purchase or sale of foreign assets were involved.

Regarding the maintenance of the fixed exchange rate regime, the

Bretton Woods System became successful. There were few

occasions when changes in the parities (exchange rate of the

currencies) were on a major scale, and a system of stability in the

exchange rate system was seen all through the 1950s and 1960s.

During this phase two important events happened. First was the

two devaluations of the British pound in 1948 and in 1967. The

second was the rise of Deutsche Mark as the German economy

recovered and her competitiveness vis-à-vis the USA increased.

The world financial system as established by the Bretton Woods

Agreement had been on a principle known as the Gold Exchange

Standard, which replaced the 19th Century Gold Standard. In this

arrangement the USA remained committed to exchange gold

against US dollar at a fixed price, which was $ 35 per ounce. Thus

the US dollar was declared international currency. Strictly speaking,

the USA only practiced full-fledged gold standard and the

commitment of dollar-gold parity at a price of $ per ounce through

Gold Window was available to the banks only. Private citizens were

not allowed to hold gold both in the USA and Europe. The important

thing is that the requirement of fixing the dollar price of gold was

the same as fixing the dollar price of other foreign currencies, since

the latter were advised to maintain fixed parity with the US dollar.

Thus the 19th Century Gold Standard was replaced by the Gold

Exchange Standard through US dollar by the Bretton Woods

Agreement.

The Bretton Woods: 1968-1973

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This period in international finance had been characterized by the

following events: the beginning of the deficits in the US current

accounts in international trade; the increasing involvement of the

USA in the Vietnam war; the increasing lack of liquidity in the world

financial system; the rise of the German deutschemark and a slow

but gradual decline in the demand for US dollars. There were

several reasons for all of these and we can narrate these briefly as

follows:

In the beginning – when the Agreement was signed in 1944 and the

exchange rate parities were fixed including the dollar – gold parity

was committed by the USA, the world was dominated by the USA

alone, and she controlled virtually the total stock of gold. Also her

industries enjoyed competitive advantage in terms of efficiency.

But as the war-ravaged Europe recovered, their industries began to

regain competitive strength. The relative improvement in

productivity situation induced powers which saw the parities of the

exchange rates vis-à-vis US dollar not conforming to the reality.

Clearly the dollar was perceived as over-valued vis-à-vis gold.

The world also saw a surge in inflation leading to sharp increase in

the prices of commodities. Thus while prices of commodities had

been rising, gold remained undervalued. So a preference for gold

developed.

World inflation was reinforced by the decision of the US

administration to resort to printing money to cover partly the

increasing domestic budget caused by the domestic poverty

programme and the Vietnam War. This cheap money policy placed

US dollar vis-à-vis deutsche mark supported by conservative

Bundesbank in a precarious position and the dollar was perceived as

overvalued. Also the increasing prices of all commodities made the

revelation that gold at a price $ 35 an ounce was a good bargain.

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Table: United States Gold Reserves and Official Liability

(Unit $bn)

Year(1)

Gold Reserve(2)

Official Liability(3)

Ratio(3: 2)

1960 17.80 21.03 1.181961 16.95 22.94 1.351962 16.06 24.27 1.511963 15.60 26.39 1.691964 15.47 29.36 1.901965 14.07 29.57 2.101966 13.24 31.02 2.341967 12.07 36.67 2.961968 10.89 38.47 3.531969 11.86 45.91 3.861970 11.07 46.96 4.241971 11.08 67.81 6.12

Source: IMF : International Financial Statistics.

Given the above perspective, whatever was warranted has

happened. To prevent the outflow of gold from the United States,

President Nixon announced the closing of Gold Window on August

15, 1971. With this the Bretton Woods System collapsed.

An attempt was made to save the system through Smithsonian

Agreement, which increased the price of gold to $ 38 an ounce from

the previous level of $ 35. But this did not become effective, and

broke down after one year.

Before the collapse of the Bretton Woods System, the very basis of

the fixed exchange rate system had been much debated in

academic circles. A relatively small but powerful section of the

profession favoured a flexible exchange rate system instead of the

fixed rate one. They argued that the disequilibrium in the domestic

money market in the form of mismatch between the aggregate

demand for and the supply of money should be allowed to be

corrected through its spill over in the external sector of the

economy in the changes of both balance of payments and exchange

rate. Instead of periodic changes, exchange rate should remain

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flexible, and this helps in keeping the domestic prices in their true

position. But the structure of the Bretton Woods system could not

adjust to the flexible exchange rate system due to the gold-dollar

parity as committed by the USA government.

The Floating Rate Era: 1973-onwards

This period of floating rates experienced a relatively high volatility

of the exchange rates. The US dollar surged ahead against all major

currencies till 1984 and then the intervention of G-10 countries

helped the sliding down of the dollar. The period also witnessed two

quick shocks due to the excessive hike of the petroleum prices in

1973 and 1977 and that induced inflation in the world and changed

the terms of trade of the petroleum importing countries. The major

characteristics of this period can be put in order.

(a) The USA experienced a large current deficit, which touched $

100 billion in 1990 with a very low saving-income ratio at the

domestic level. On the other hand Germany and Japan

experienced large current account surplus.

(b) There has been a global insolvency problem as a large number

of countries became unable to service their debts. The petro

dollars in the initial period were recycled by the international

banks to the needy Third World countries at high nominal

interest rates. Subsequently inflation came down, but interest

rate did not. This led to a substantial rise in real interest rate

and put a higher debt burden on the developing countries.

(c) There has been a definite change in the balance of economic

power in the world with the rise of Japan and Germany as

economic power houses. Particularly, Japan supplied capital to

a large number of countries including the USA. On the other

hand Germany along with European Union has become a

significant economic force to reckon with.

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(d) The world has also seen huge amounts of trans-border capital

flows and this has been helped by technological innovation.

There has been a phenomenal increase in the volume of

business of international forex market and international market

of derivatives. In 1997 the average daily transaction of

international forex market reached $ 3 trillion.

(e) Along with the increase in business there has been a

perceptible increase in the volatility in the market. This is the

result of increasing uncertainty about the perception of the

market operations. But this increasing risk factor has induced

development in the derivative market.

On November 1, 1993 the Maastricht Treaty came into force and

created the European Union. By the end of 1997, eleven members

of EU have fulfilled the criteria for the launch of the common

currency EURO from January 1, 1999. When Euro will replace the

currencies of the members on January 1, 2002, it will be the

currency of one of the largest economic blocks of the world. Then

its relation with the US dollar will be worthy of watching.

The floating exchange rate regime (since 1973) ultimately became

unsatisfactory at the international level. This was mainly due to

three reasons. First, inflation had been a common world

phenomenon and there was hardly any uniformity regarding this in

member countries. This was because of the divergent macro

economic policies followed by the members.

Second, the world economy was subject to two severe shocks, the

OPEC oil price hike in 1973 and 1979. It was difficult for any

exchange rate mechanism to absorb this shock. It reinforced

inflation in the oil importing countries and altered the terms of

trade.

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Third, the international financial system was being dominated by

the rising tide of international capital flows. This started creating

uncertainty and consequently the exchange rate volatility

increased.

The USA on the one side and Europe and Japan on the other were

advancing disparate arguments at diplomatic levels for the stability

of the exchange rate system. While the USA was arguing that Japan

and Europe should adopt expansionist policies so that the USA could

increase exports and cut down deficits in current accounts, Japan

argued that the USA should take measures to reduce budget deficit,

as the latter was the root cause of the current account deficit.

In September 1985 the finance ministers of the G-7 countries met in

Plaza Hotel in New York and reached an agreement that the US

dollar should be allowed to fall. They agreed to a target zone for the

US dollar. In February, 1987 the ministers of G-7 met again, at

Louvre in Paris and agreed that the fall of the US dollar had been

adequate and should be stabilised.

Since the Plaza-Louvre accord the central banks of G-7 countries

have conducted concerted interventions several times for the

stabilization of the dollar and they have been successful. On certain

occasions central banks of three countries intervened in unison and

have been able to achieve the targets.

The relationship between IMF and the G-7 countries (the USA,

Canada, France, Germany, Italy, Japan, the United Kingdom) is

unique in the sense that these countries have a long history of

meeting on economic and financial matters of common concern at

intervals since 1970. The arrangement was formalized at the 1982

Versailles Summit of the G-7, where these seven countries declared

their eagerness to strengthen their cooperation with the IMF in its

work of surveillance. During the period 1981 to 1985 the USA

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followed a policy of “benign neglect” regarding the exchange rate of

the dollar and G-7 countries became active for the stabilization of

the exchange rate regime. Since then these countries have been

active for the management of the world exchange rate system.

The power the G-7 countries exercise in the management of the

world financial system is derived from the voting power within the

IMF. These countries control about 47 per cent of the votes in the

Board of Governors of the IMF and slightly over 50 per cent in the

Executive Board. In the latter the Canadian and Italian directors

exercise the votes of all countries that have elected them and

where the voting power of a few new members is not exercised.

Prices in an Open Economy

In any economic system taxation and subsidies, the most powerful

tools in the hands of the government, create distortion in the

system of pricing and economists thus remain satisfied with the

second best solution. But assuming that no tax is there, the price of

a commodity should reflect the true opportunity cost, both from the

producer’s side and from the consumer’s side. This also leads to

the Law of One Price, which states:

If two goods are identical, they must sell for the same price.

The implication of the above statement is that if the statement does

not hold, some people will take advantage of it to make money.

This process is known as arbitrage, which is defined as:

Arbitrage is an action of buying or selling some commodity in

order to exploit a price differential so as to make a profit.

Over time the Law of One Price holds through the actions of

arbitrage by the economic agents. What is true for the domestic

economy is also true for the international transactions of

commodities. Both India and Sri Lanka are the exporters of tea. If

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the two quotations in the international market are different for the

same quality of tea, some traders will resort to arbitrage operations

to make a profit. What is true for tea is true for all types of

commodities. This is one area where market forces act precisely

like the laws of physics.

One should be cautious about the differences between arbitrage and

speculation. Speculation is defined as activity of holding goods in

the hope of profiting from a future rise in their prices. The core of

speculations is having or creating a stake on the uncertainty about

the future. Thus in a market one finds three categories of economic

agents: the traders, the arbitrageurs and the speculators. In reality,

though sometimes actions of these three classes overlap.

Exchange Rates

In international market, currency is traded like a commodity. Why is

the currency of a foreign country needed?

The answer is that if an Indian trader wants to buy colour picture

tubes from Japan, the seller in Japan is to be paid in Japanese Yen.

Now the Indian trader has to concert the Indian rupees into yen by

buying Japanese Yen in the foreign exchange market, which should

be properly called as foreign currency market. The price of foreign

currency is known as the exchange rate. Hence the definition is :

The exchange rate or a currency, say Indian Rupee, is the

Rupee value of foreign currency, say US dollar.

Thus when we quote US $ 1 = Rs.39.60, we simply say that

Rs.39.60 is to be paid to have one US dollar.

All exchange rate quotations comes as two-way quotes, or bid-offer

rates. The bid rate for US dollar in terms of the Rupee is the rate at

which dealers buy dollar and sell rupees. Again, the offer rate of ask

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rate is the rate at which the dealer sells dollars and buys rupee.

Also the bid/ask spread is the gap between the offer rate and bid

rate.

Exchange rate information comes either as spot rate or as forward

rate. The spot rate is relevant for a current transaction, i.e. the

exchange of the two currencies take place at the present time,

though in the international market spot delivery can stretch upto 48

hours.

The forward rate is the price of a currency in terms of the domestic

currency when the delivery will take place along with the payments

at some future date, say after 90 days or 180 days. It is a future

contract between two parities.

The Relation between Spot and Forward Rates

Like any commodity the present and future prices of a currency

differ; but unlike the ordinary commodity prices, here the two prices

are linked up precisely by an important economic parameter, that is

the interest rate. To reach that conclusion two concepts require

explanation – the Uncovered Interest Rate Parity condition, and

Covered Interest Rate Parity condition.

The uncovered interest rate parity condition (UIRP) states that the

domestic interest rate must be higher than the foreign interest rate

by an amount equal to the expected depreciation of the domestic

currency, or

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i = i* + x (1)

where x is the expected depreciation of the domestic currency (the

domestic interest rate) and i* the foreign rate. When the domestic

currency is stronger, domestic interest rate becomes less than

foreign rate and the domestic currency appreciates.

The UIRP condition is also known in international finance literature

by another name, or the international Fisher Equation. The

implication is that the domestic nominal interest rate should

compensate adequately the expected depreciation of the domestic

currency. When this is not the case, slight of domestic currency

takes place, which is nothing but capital flight from the country.

The covered interest parity condition (CIRP) states that the domestic

interest rate must be higher than the foreign interest rate by an

amount equal to the forward discount on the domestic currency.

We can write this in equation form as:

Equations (2), (3) and (4) are equivalent expression. Here F and S

stand for forward rate and spot rate respectively for the domestic

currency. Using the direct quote norm, it is clear from equation (4)

that if the domestic interest rate rises and becomes higher than the

foreign interest rate, the second term on the right determines the

premium for the foreign currency, which is equivalent to saying that

if domestic currency is sold at discount, the latter is determined by

the interest differential.

Equation (4) also guides the market arbitrage conditions, as the

participants always monitor the movement of the domestic interest

rate i vis-à-vis the foreign rate i*. Whenever the market values give

inequality in equation (4), perfect arbitrage dictates sale or

purchase of the currency to take advantage of the interest

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differential. Thus the market forces again restore the equality which

is the equilibrium situation of the market.

There is a hypothesis which states that forward rate is the unbiased

predictor of the future spot rate. There has been scores of paper

empirically testing the relationship between the two rates. Some

recent results are worth mentioning:

For the period May 1980 to March 1990, the monthly data of

Japanese Yen were used to estimate the econometric equation as:

Spot (t) = a0 + a1 Forward rate (t-1) + error

The estimation gives the result like:

St = -0.0057 + 1.0005 Ft-1 + e

t-value (-0.0019) (69.94)

R-2 = 0.978, SER = 7.248, n = 110

For deutschemark and for the same period, the estimation result is:

St = 0.0278 + 0.99 Ft-1 +e

t- value (0.6398) (53.38)

R2 = 0.963

SER = 0.084

N = 110

Both the results clearly show that intercept term is not significant

and one period lag value of forward rate determines the spot rate

with high degree of accuracy. This econometric results help to have

an understanding of where the rate is going in the immediate

future.

The participants’ conjecture about the potential price movement is

conditional on the assumption of full information set. This is

possible in an efficient market.

Efficient Market Hypothesis

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The concept of market efficiency was first developed in the finance

literature and its full form was first explained by Engene Fama. But

now-a-days this concept is being used in other areas also. Efficient

market is defined as one where prices fully reflect all the available

information. By definition then there should not exist any

unexplained opportunities for profit.

The definition of efficient market is a little vague and its vagueness

it seems, is intentional. It can be shown that, under certain

circumstances, it is not required all market operators to share

exactly identical views on the future price. Some investors may be

better informed than others.

The implication of the concept of market efficiency in forex market

is interesting. Let us assume that both spot and forward markets of

a currency are characterized by the following condition: (a) There

are a large number of investors with ample funds available for

arbitrage operations, and (b) There are not exchange controls and

also no transaction costs.

In this situation suppose an American investors thinks that spot

price of deutsche mark (DM) in terms of the dollar is going to be 15

per cent higher in twelve months than it is to day. The investor may

be able to profit by buying DM forward, and then selling DM spot at

the end of 12 months. If his judgment proves right, his profit will be

15 per cent less the premium paid for forward DM (transaction cost

is nil as assumed). As the market information is perfect, other

investors will follow suit, and the forward DM will be bid up until the

premium is high enough to prevent any further speculation.

One interesting question is: how long will the speculation continue

in the market to have a share of the profit. This is not indefinite, as

at some point investors will realize that, although the potential of

profit from speculation is not zero, the probable reward is not great

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enough to compensate for the risk of being wrong. Thus equilibrium

will be reached and speculation will spot at the point where the gap

between the forward rate and the expectation of the market of the

future spot rate is just equal to the required risk premium charged,

or in equation it becomes

Ft (t+1) = Et(St+1) + rt

Where LHS is the logarithm of forward price of DM at time t for

delivery at period (t+1) and rt is the risk premium. In the above

equation the forward rate reflects both the publicly available

information congealed in the rational expectation Et(St+1) and the

attitude of the market towards risk revealed in the risk premium.

Thus the equation shows the equilibrium in the efficient market.

The interpretation of efficiency explained here corresponds to what

E. Fama called semi-strong form of efficiency (FAMA, 1970). Strong

form of efficiency applies when the market price reflects all

information, whether publicly available or not.

It is quite possible to imagine a situation where the market price

reflects only the restricted information set which can be used in the

formation of weakly rational expectations. Here the expected value

in the equation would be conditioned on the past value of the time

series, and not on the universe of publicly available information.

This helps in defining a weakly efficient market.

A weakly efficient market is one where the market price

reflects the market information in its own past history. It

implies that there no longer exists any opportunity to profit

by making use of past time series of prices alone.

One interesting aspect of weakly efficient market is that there will

normally remain opportunities to make a profit by the exploitation of

information additional to the past time series of prices. Another

implication of market efficiency is the unbiasedness of the market.

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A forex market is said to be unbiased when the forward market is

efficient and investors are risk neutral, so that the forward rate is

equal to the mathematical expectation of the spot rate at the time

of the maturation of the contract.

Efficient of inefficient players in the forex market are big and they

are equipped with very powerful computers with dedicated

software. In spite of the fact that they have access to massive data

set and powerful software, calculations go wrong and survey data

repeatedly point out irrational movement of expectations. May be

this is another mystery of the market forces.

Reference:

Fama E F, Efficient Capital Markets: A Review of Theory and

Empirical Evidence, Journal of Finance, 25, 1970, 383-417

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2. Exchange Rate Pass – through

According to Bhagawati (1991) the phrase “pass-through” was first

used in economics literature by Steve Magee (1973) in his paper

while explaining the impact of currency depreciation. Since then

the concept has been widely used in the literature. In the case of

international trade the suppliers of commodities deal with two

currencies, the domestic currency against which commodities are

procured, and the destination currency, the currencies of the

importing country. Similarly, the importers of the commodities also

face two currencies. With the breakdown of the Bretton Woods

System in 1973, the international financial system opted largely for

the flexible exchange rate system. Along with this world has

witnessed an increasing degree of volatility. When a particular

currency depreciates vis-à-vis US dollar, then the prices of traded

goods denominated in the depreciation currency will increase.

Suppose the depreciating currency is the Indian rupee and the

international reference currency is the US dollar. As the rupee

depreciates, the prices of imported goods in the Indian domestic

market should increase. Suppose the rupee depreciates by 10 per

cent in a given period other things remaining the same, the prices of

imported goods should rise by 10 per cent approximately. But in

reality the traders may not pass on the full impact of price change

due to the depreciation. This is the pass-through puzzle, as

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exchange rate destination currency prices of the internationally

traded goods. Suppose in our taken example the prices of the

imported goods increase by 70 per cent then in this case the pass-

through is 70 per cent.

The idea of pass-through has two connotations: (i) the pricing of

destination on currency closely follows the procedure of imperfect

competition; and (ii) the asymmetry of price change relative to the

change in the exchange rate is connected to the concept of

elasticity consideration in international trade. The elasticity

approach used in the explanation of change of trade assumes that

pass-through is complete and so the effects of price change on

demand or supply can be studied. If exchange rate changes are not

reflected in the selling prices of the traded commodities, the

expected quantity adjustment will be retarded even when the price

elasticity is sufficiently large. Thus the degree of pass-through can

effectively influence the channels of the elasticity operations. This

has another implication. If there exists a significant lag in the

transmission of exchange rate changes to the prices, and also there

are lags in price- quantity change operations, then the efforts of

adjustment in the balance of trade through the change in the

exchange rate may be severely affected. Thus pass-through deals

with this international transmission mechanism.

The inadequate response in the change of destination prices

resultant to the exchange rate changes is linked to the existence of

imperfect competition. Here the structure of the market is

important. For the explanation of the role of the market structure in

determining the pass-through relationship, it is useful to start with a

competitive market with imported goods which are perfect

substitutes of domestically produced goods. Also, the pricing of the

goods will follow the marginal costs, and the elasticity affecting both

the demand and supply of the goods response to the change in cost

conditions through their reflection in prices.

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Under imperfect competition, pricing will not follow the marginal

cost rule, and the firms will use mark-up in prices even in a long run

situation. So in response to the change in the exchange rate, this

mark-up varies which is important. This relates the variation in the

profit margin to the degree of pass-through. The sellers think about

the maintenance of their market share even at the cost of a

squeezed profit margin.

In a paper Dourbusch (1987) has considered the Dixit-Stiglitz (1977)

and the Salop (1979) model of competition to capture the effects of

imperfect substitutability and product differentiation on price

response to the changes in the exchange rates. He concludes that

the degree of pass-through is directly related to the degree of

substitution between the imported goods and domestic produced

goods. Using the cases of firms as Bertrand competitors, Fischer

(1989) finds that in a segmented market with limited arbitrage an

appreciation of the domestic currency will lead to a higher pass-

through if the domestic market is monopolistic relative to the

foreign market.

Two things are important in the market structure: the degree of

substitution between goods and domestically produced goods and

the nature of segmentation of the market. The studies in the

literature regarding the extent of pass-through [Isard (1977), Kravis

and Lipsey (1978), Richardson (1978), Ohno (1989), Knetter (1989,

Marston (1990) and Kasa (1992)] generally support the view that

there are significant differences in the pricing behaviour of firms in

response to exchange rate changes, as a result of less than perfect

substitution of goods between imports and domestically produced

ones or the presence of segmented markets. Also in an open

economy the presence of foreign firms in the domestic market

affects the degree of pass-through (Dornbusch, 1987; Sibert, 1992).

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The existence of foreign firms in the domestic market leads to the

role of multinational corporations (MNC) and intra-firm trade in

influencing the degree of pass-through. While the volatility of

exchange rates is sometimes extreme, prices in domestic markets

cannot swing a lot. Realizing this, MNCs use their subsidiaries in

intra-firm pricing to prevent the full transmission of exchange rate

changes in domestic prices. In this connection Holmes (1978) finds

that the existence of a directly owned sales subsidiary is a helpful

factor in enabling the firm to fix prices in such a way that it creates

minimum effects in the market. These sorts of practices have been

corroborated by Dunn (1970) also in the case of Canada.

One standard practice of the MNCs is that they use internal of intra-

corporate exchange rates in the case of intra-firm transactions. The

latter type of transactions generally occur between a parent firm

and its wholly-owned subsidiaries, or majority-owned affiliate or

between two subsidiary firms. The intra-corporate exchange rate

may deviate significantly from the true one for a long period, as this

is used as a clearing mechanism for intra-firm trade. The MNCs use

this sort of pricing mechanism to optimize profit in their global

operations (Helleiner, 1985).

The Hysterises

Prof. Krugman (1987) has distinguished static and dynamic pass-

through models. In the former the firms can price to market as they

can resort to price discrimination between domestic and foreign

markets. But dynamic models should have multi-period effects on

both the supply and demand side. Some types of inter-temporal

effects on demand like network externalities, multi-period pricing

and advertising effects on demand like network externalities, multi-

period pricing and advertising effects, etc., may cause incomplete

pass-through (Froot and Klemperer, 1989). On the other hand

supply relation can have some traces of adjustment cost as

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emphasized in Kasa (1992). Also when exchange rate fluctuation is

either anticipated or expected to reverse, supply relational can face

capacity constraints, which cause price stickiness.

In the imperfect competition-setting sellers sometimes resort to

pricing to market thus making pass-through incomplete, though the

unexpected change in the exchange rate may have some

contribution to that. The separation of the effects of the two forces

has been done in Giovannini (1988) and Marston (1990).

The emphasis on the dynamic and inter-temporal behaviour in the

pass-through process has implications in the “hysteresis” models of

the pricing of traded goods. These types of models depend on the

concept of sunk cost associated with entry exit decision in the world

market. The idea is that the uncertain climate of flexible and

floating exchange rate has induced the firm to follow a ‘wait and

watch’ policy regarding the decision of entry or exit from the trade.

This type of inertia gets reinforced when significant sunk costs are

involved, which may in the form of the establishment of a

distribution network. For example:

The hysteresis effects (Baldwin, 1988; Krugman, 1989; Dixit 1989)

suggests that the nature of competition in the market will not

change so long as exchange rate fluctuations remain within a

specific band, and the size of this band depends positively with the

amount of costs involved with the entry and exit of the firms. This

reduces the degree of pass-through. The idea of hysteresis in the

process of exchange rate changes has been extended in other areas

like money supply, as in Uribe (1997).

21

Theory of Exchange Rate Pass-Through: Microeconomics

Let the demand and supply functions of the imported goods be:

Qd = D (Pd) demand function (1)

Qs = S (Pf.E) supply function (2)

Where Pd and Pf are domestic and foreign currency price and E is

the exchange rate, or the price of domestic currency in terms of

foreign currency.

From (1) and (ii) after differentiation:

(3)

(4)

For equilibrium in the market: dQd = dQs

or,

or,

or,

or,

or,

or, (5)

What is the definition of exchange rate pass-through? It is the

change in the domestic price of the imported goods for the changes

22

in the exchange rate, and let Z stand for the index of pass-through.

So we can write:

It is the formula of elasticity. We can also define some other

elasticities. The supply elasticity of imported goods with respect to

exchange rate changes is:

Similarly, and so on.

So from (5) we write:

Since and as S = D in equation.

or writing in terms of elasticities, we have:

23

Or the degree of pass through Z depends on three elasticities: the

elasticity of supply of imported goods with respect to exchange rate,

the elasticity of supply with respect to foreign price and the

elasticity of demand with respect to domestic price.

While the algebra shows the mathematical relation of the degree of

pass-through, the same can be shown in the diagram, which

resembles the famous tariff diagram.

Let the two axis show quality of American exports to India (or

imports in India from USA) and rupee price of American exports. Let

us assume that rupee depreciates by 10 per cent and imports

become costlier in terms of rupees. DD and SS are the demand and

supply curves of imported goods in India from the US. As a result of

depreciation of rupee supply the curve shifts up and equilibrium

price changes from E to B. Now pass through in 100 per cent if

price increases to point A, but it is less than that and in fact pass

through is only CE/AE. This analysis holds in the context of perfect

competition and unrestricted trade. But degree of pass-through can

be influenced and even made to zero if quantity restrictions are

imposed along with exchange rate changes. (Bhagwati, 1991).

24

D

S1

S

S1

D

A

C

E

B

O

Prices of American exports in Indian rupees

25

Quantity of American exports to India

In today’s world trade organization, free trade rules out quantity

restrictions, but as Bhagwati (1991) has mentioned, the size of the

pass-through can change by the shift of the demand and supply

curve over time. Of course we have perceived the formula of pass-

through in terms of the elasticity of demand and supply curves. In

imperfect market conditions sellers can control the prices and

pricing to market (PTM) follows depending on the market conditions

and the decision of the seller for the maintenance of the market

share.

This aspect of pass-through shows the limitations of the attempt to

control imports and/or exports by the adjustment of exchange rate

in the case of dirty float of the currency. Unless pass-through is 100

per cent, this type of efforts may not be meaningful. Given that

pass-through becomes incomplete, aggressive depreciation of the

currencies with the objective of increasing the exports of the

country may lead to adverse movement of terms of trade and

insignificant increase in the volume of exports.

Another aspect of pass-through is that to what extent the traders in

an imperfect market will be ready to adjust the prices

commensurate to the change in the exchange rate. This is pricing to

the market (PTM) and judging by its importance it is discussed in a

separate chapter.

26

3. Pricing to Markets

One important aspect of Purchasing Power Parity (PPP) doctrine is

its espousal of law of one price, i.e. assuming one-way transport

costs and tariffs. A HMT watch will be priced the same whether it is

sold either in Mumbai or New York. But in the literature of

international finance two stylized facts are prominently mentioned.

First, real exchange rate movements are seen to be very persistent

at the aggregate level of the economy. Second, individual prices of

traded commodities tend to be sticky in terms of local currency at

the micro level. Engel (1993) has compared the relative prices of

different commodities within the same country versus relative price

of the same commodity across different countries and he has

reached the conclusion that the former measure is less variable in

all but a few cases such as primary commodities and energy. Also

Engel finds that the second relative price tends to be more volatile

in nature and this proves that local prices in a given market remain

comparatively stable.

The open economy models of the Keynesian tradition incorporate

price stickiness and thus explain the overshooting of the exchange

27

rate (Dorbush, 1976). But Keynesians often do not discuss the price

stickiness at the buyer’s end that is in the currency of the

destination, though price stickiness at sellers’ end is discussed. The

law of one price coming from the standard PPP theory cannot

explain the degree of persistence that is observed in real exchange

rate series. It is seen that real and nominal exchange rates move

together both in the short and in the long run.

The law of one price derived from PPP is used to explain the spatial

arbitrage, as net of tariffs and transport cost. The price of a traded

commodity should be the same bought anywhere in the world. On

this Krugman (1989) writes:

[W]e must now admit that international Keynesianism, while

more like reality than International monetarism, itself turns

out to have a problem. It is not so far enough in rejecting

international arbitrage. Not only does the Law of One Price

fail to hold at the level of aggregate national price indices …

it does not even hold at the level of individual goods (p. 43).

The law of one price has been subject to modifications and one such

is pricing to market (PTM). The latter allows corresponding prices to

diverge across markets favouring market segmentations and thus it

negates spatial arbitrage. Thus across the countries economic

barriers and structural rigidities persists which makes law of one

price non-functional. Thus when the US dollar had been

appreciating in the early 1980s, Dornbusch (1987) observes: export

prices change little relative to domestic prices, even though there is

no clear pattern of decline in all industries. By contrast, most

import prices decline in terms of domestic goods. But the order of

magnitude of the decline (in import prices) remains relatively small

compared to the change in relative unit labour cost. With a change

in unit labour costs of more than 40 per cent, the decline in the

relative price is in most cases less than 20 per cent. This is not at

28

all out of line with the theory once some degree of “pricing to the

American market” is taken into account … (p. 104).

When the dollar depreciated during the period 1985-87, the import

prices of Japanese manufactures in USA market did not rise

proportionately.

When we allow the producers to price discriminate between local

and foreign markets in the framework of the monetary model, it is

possible to examine exchange rate pass-through and price to

market behaviour under the assumptions of markets segmentation

and relative price dynamics under nominal rigidities. In this

framework the structure of trade can be incorporated and then it

becomes possible to examine the cross-sectional implications of

inter-sectoral versus intra-industry trade for macroeconomic

adjustment.

‘The country generally follows a specific pattern of industrialization.

This pattern of industry specialization and trade determines the

degree of strategic complementarity or price linkages between

producers from different countries. In the context of intra-industry

trade there exists a high degree of linkage between home and

foreign good prices prevailing in the same market as home and

foreign products become close substitutes. This linkage is not so

strong under inter-industry trade. The result is that domestic and

export prices show greater responsiveness to the fluctuations of

exchange rates. Further, this induces a lower degree of

passthrough, as a greater degree of pricing to market under two-

way trade.

When integration in the world market for commodities is not perfect,

countries differ in their national consumption pattern and in the

units of accounts in which prices are set. This is done to favour their

own goods and own currency. But the law of one price holds and

this ultimately equates currency adjusted prices across the different

29

markets (Krugman, 1989). Under imperfect integration a greater

degree of price linkages across countries translates into stronger

mean reversion in the real exchange rate. The explanation is as

follows: When production costs and prices move in a zigzag fashion,

prices of commodities show intertia in terms of national currency

unit as the economic agents work without any coordination. When

the economy is open producers (exporters) are to consider both

domestic and foreign market prices. The latter being less flexible,

the producers are to see that domestic prices remain flexible. Thus

prices become less rigid in terms of national currency so that

variation in term of foreign currency is reduced. Thus strong

international linkage under two-way trade reduces the variability

and persistence of real exchange rate fluctuation compared to

intersectoral trade.

This remains true as long as the assumption of spatial arbitrage

holds. Once this is gone, the former conclusion no longer remains

tenable. As obstacles are created both in the form of quantity

restrictions or tariff barriers, price discriminations persist and

variability of real exchange rate increases.

According to Faruquee (1995) pricing to market ensures greater

price stability in terms of local currency than the alternative pricing

system when especially exchange rate pass-through is more or less

complete. Compared to the law of one price, market segmentation

allows greater inertia in the domestic price level, but international

relative prices adjust slowly. This way pricing to market (PTM)

provides an important propagation mechanism for the explanation

of large and protacted swings in the real exchange rates which have

been a common phenomenon in the post-Brettonwoods period. This

has monetary shocks have enduring effects on relative prices, and

this induces nominal and real exchange rates move together in the

short run, and these two move together in the longer run as well,

when monetary shocks have permanent effects.

30

A Theoretical Model

The theory of pricing to market (PTM) can be explained with

theoretical depth and rigour with the help of a model following

standard literature of modern trade theory. In the two country

framework let the world economy consists of a home country and a

foreign country each having N product consumers. The latter

produce and sell differentiated goods in order to exchange

commodities made by all agents by all agents taking their prices as

given. Each agents behaves like a monopolist, and he sets the price

and equilibrium quantity of produce depending on the market

demand. Two basic aspects of the constant elasticity of substitution

framework of Dixit and Stiglitz (1977) can be focused in the model

and these are: inter-sectoral trade and intra-industry trade. In the

former, the law of comparative advantage holds and countries

specialize at the industry level depending upon underlying

differences in relative factor proportions. Only the extension from

the traditional Hecksher-Ohlien theory is that each industrial sector

is characterized by monopolistic competition.

The intra-industry trade is different, as countries are homogenous

regarding factor-proportions. But even then they can gain from

specialization and trade at the variety level because of scale

economies and product differentiation.

The Consumer’s Problem

For the home country agent i has the utility function as:

(1)

Here Ci is a consumption basket of home and foreign goods, M i is

the money holdings of home currency, Q is the domestic consumer

price index, and Y1 and Y2 are respectively the level of output of

31

domestic and export markets of agent. Fi denotes the fixed cost.

Also q and (1-q) represents the constant expenditure shares of

goods and money, and (g-1) is the elasticity of marginal disutility

with respect to output.

Inter-sectoral Trade

In case of inter-sectoral trade economic agents consume both

domestic and foreign goods. The utility of the agents depend on the

consumption of both the goods. We can write the consumption

function in CES form as:

(2)

Where Ci* represents agent is consumption basket of all home

goods and Ci** consumption basket of all foreign goods.

The consumption basket of home goods can be written as:

(4)

assuming that in each case n number of goods enter into the

consumption basket. Also e measures the constant elasticity of

substitution between any two home or any two foreign varieties

respectively. Thus e measures the way the agent substitutes in

between any two domestic goods or any two foreign goods and the

division in which domestic and foreign goods enter into the

consumption basket of the agent is determined by equation (2).

Intra-industry Trade

When intra-industry trade takes place, home and foreign made

goods do not belong to separate commodity groups, because

32

countries exchange goods within the same industry. So the

substitution between home and foreign made goods on the part of

the economic agents are not applicable in this case. Accordingly

equations (2) to (4) are modified and are to be replaced by the

following:

(5)

Here b measures home goods preferences. Though home and

foreign made goods are of the same type and serve identical

purposes, it is assumed that economic agents have preferences for

the home made goods.

To complete the formulation of the consumer’s problem faced by

the economic agent we are to bring the budget constraint and this

is:

(6)

This is the budget constraint of i th agent, P j is the price of home

good j in domestic currency and Pj* is the price of foreign goods in

foreign currency. E is the nominal exchange rate i.e. home currency

price of foreign currency and li is the nominal wealth of agent i.

Case of Intersectoral Trade: Optimisation

In the case of intersectoral trade the problem of the consumer agent

is to maximise equation (1) with respect to C ij*, Cij

** and Mi subject to

equation (6) i.e., budget constrain, while equation (2) to (4) are

given. The first order conditions and the solutions of these give the

following:

33

(7)

Where

Which is the demand function of domestic goods. Again,

(8)

This is the demand function for foreign goods. Finally we have:

Mi = (1-q) . li (9)Which is demand function for money.

Intra-industry Trade

For intra-industry trade equation (5) is important. Given equation

(5) consumer’s maximization problem boils down to maximization of

(1) with respect to Cij**, Cij

** and Mi subject to equation (6), the

budget constraint. The solution of the first order condition gives:

(10)

This gives the demand function for home variety goods

(11)

and this gives the demand function for foreign goods.

34

Summing up the individual demands for each home produced goods

in equation (7) or equation (10) over all the consumers at home

along with the equivalent export demands over foreign consumers

give the product demand facing the domestic producer of goods.

This can be written as:

(12)

Thus the demand for a particular product consumed both at home

and abroad faced by a representative producer is a function of

relative price and real wealth at home and abroad. This is for inter-

industry trade.

For intra-industry trade the aggregate demand for a commodity

faced by a representative producer is:

(13)

This is for the home market. For foreign market this becomes

(14)

Assuming that economic agents have a strong preference for home

produced goods, and , these parameters help identify

the nominal expenditure share allocated to locally produced goods

from each country. With inter-industry trade the domestic Consumer

Price Index (CPI) becomes a function of prevailing home and foreign

producer prices and this can be written as:

Q = pa (E P*)1-a (15)

35

Where a is the exact expenditure share on home goods. Under

intra-industry trade the consumer price index (CPI) at home can be

written as:

(16)

Also the expenditure share on home goods can be written as:

(17)

When the relative producer prices are in general equilibrium, b is

chosen such that a = , i.e., keeping the expenditure pattern

identical with the trade pattern.

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