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

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Motors in the USA can procure different components of cars from
Hindustan Motors of India. In such international transaction there
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

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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
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

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replaced by the Gold Exchange Standard through US dollar by the
Bretton Woods Agreement.

The Bretton Woods: 1968-1973

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

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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.

Table: United States Gold Reserves and Official Liability

(Unit $bn)
Year Gold Reserve Official Liability Ratio
(1) (2) (3) (3: 2)
1960 17.80 21.03 1.18
1961 16.95 22.94 1.35
1962 16.06 24.27 1.51
1963 15.60 26.39 1.69
1964 15.47 29.36 1.90
1965 14.07 29.57 2.10
1966 13.24 31.02 2.34
1967 12.07 36.67 2.96
1968 10.89 38.47 3.53
1969 11.86 45.91 3.86
1970 11.07 46.96 4.24
1971 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

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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
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,

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 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.

(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.

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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.

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.

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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
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

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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
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?

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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 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.

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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

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

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by an amount equal to the forward discount on the domestic
currency. We can write this in equation form as:

S (1 = i )  ( i − i *) 
(1 = i ) = (1 + i *) F (2) or F = (3) or F = S + S   (4)
S (1 = i*)  ( 1 + i*) 

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
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)

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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

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

14
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
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

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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.

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.

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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
exchange rate destination currency prices of the internationally
traded goods. Suppose in our taken example the prices of the

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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

20
affects the degree of pass-through (Dornbusch, 1987; Sibert,
1992).
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,

21
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 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).

22
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:

∂D
d Qd = . ∂Pd = D pd . dPd (3)
∂Pd
1 P 
d Qs = S E . dE + S pf . dPf = S e . dE + S pf .  .dPd − d2  (4)
E E 
For equilibrium in the market: dQd = dQs

1 P
or, D pd dPd = S E . dE + S pf . dPd . − S pf . d2
E E
d Pd dP 1 P 1
or, D pd . = S E + S pf . d . − S pf . d2 .
dE dE E E DE

d Pd  1 Pd 1
or,  pd
D − S pf . =
 E S − S pf . 2
.
dE  E E dE

23
 d Pd E  1 e P 1 E
or, .  D pd − S pf .  = S e . − S pf . d2 . .
d E Pd  E Pd E d E Pd
d Pd E  1 E 1
or, .  D pd − S pf .  = S E . − S pf .
d E Pd  E Pd E . dE
E 1 1
SE . − S pf .
d Pd E Pd E dE
or, . = (5)
d E Pd 1
D pd − S pf .
E
What is the definition of exchange rate pass-through? It is the
change in the domestic price of the imported goods for the changes
in the exchange rate, and let Z stand for the index of pass-through.
So we can write:

d Pd / Pd d Pd E
Z= = .
d E/E d E Pd

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:

d S/S dS / S
ηS , E = Similarly, η S , Pd = and so on.
dE / E d Pd / Pd
So from (5) we write:

dS E S d S Pf 1 S
. − . . .
d Pd E d E S Pd d Pf S E . dE Pf
. =
d E Pd d D Pd D d S Pf 1 S
. . − . . .
d Pd D Pd d Pf S E Pf

24
 dS E S dS S 1
. . − . .
d e S Pd d Pf d E E.Pf
=
d D Pd D d S Pf S
. . − . .
Pd D Pd d Pf S E Pf

 dS E S  d S Pf  1 S
 . − . . .
 d E dP S  dE P
S  Pd
=  f  d

 d D Pd  D  d S S  S
 .  . −  . .
 
 Pd D  Pd  d Pf Pd  Pd
D S
Since Pd = E . Pf and = as S = D in equation.
Pd Pd

DS E  d S Pf  . 1
. − .
dE S   d Pf S  dE
=
d D Pd d S Pf
. − .
Pd D d Pf S
or writing in terms of elasticities, we have:
1
ηS , E −ηS , Pf .
Z = E
ηD , Pd −ηS , Pf

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.

25
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).

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 Quantity of American exports to India
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

26
D
S1
 Prices of
American B
exports in C
Indian
movement
rupeesof terms of trade and insignificant increase in the volume
of exports. E
1
S
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
S D
the market (PTM) and judging by its importance it is discussed in a
separate chapter. O

3. Pricing to Markets

27
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
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:

28
 [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
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

29
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 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

30
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.

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

31
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:
q 1− q
C
U i =  i
  Mi /Q 
 .   − ( )
1 1
Yi
g
− ( )
1 2
Yi
g
− Fi (1)
 q   1− q  g g
Here Ci is a consumption basket of home and foreign goods, Mi 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
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.

32
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:

a 1− a
 Ci *   Ci **  1
Ci =   
 1− a 
 ; < a<1 (2)
 a    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:

e
n
( ) 
1 e −1 e −1
= ∑ Cij
* ∗
Ci = ( n) 1−e e
 , e >1 (4)

 j =1 

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
countries exchange goods within the same industry. So the

33
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:

∑ (Ci )
1  1 e −1

C i = ( n ) 1− e  ∑ ( C )
n e −1 1 n e −1
1
+ (1 − b )
** e
*
ij e e
j  < b<1 (5)
 be j =1 j =1  2

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:

n n

∑ Pj C + ∑ E Pj C ij + M i = li
* * **
ij (6)
j =1 j =1

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 Cij*, 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:

34
 −e
 Pj   aq l i 
=     for j = 1,...n,
*
C ij (7)
P   nP 
1
1 n 1−e 
1−e

n ∑ j 
P =
Where P 
 j =1 

Which is the demand function of domestic goods. Again,

−e
 Pj *   ( 1 − a ) q . li 
= * 
**
Cij   for j = 1, 2, ...n (8)
P   n E P *

 
1
1 n 1−e  1−e
where P * = ∑ 
*
n Pj 
 j =1 

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:

−e
 Pj   bq l i 
=     for = 1, 2,....n
*
C ij (10)
Q   nQ 

35
This gives the demand function for home variety goods

−e
 E Pj *   (1 − b ) . q li 
=    for = 1, 2,....n
*
Ci j (11)
 Q   n Q 
 

and this gives the demand function for foreign goods.

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:

−e
P   M  EM*
Yi =  i   a  + (1 − a )  (12)
P  P  P 

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:

−e
 Pi   bM 
Yi = 
Q 
 
 Q 
 (13)
   

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

−e
 P   M 
Yi =  i *   (1 − b ) . 
* 
(14)
 EQ   E Q 

36
Assuming that economic agents have a strong preference for home

1 1
produced goods, < a < 1 and < b < 1 , these parameters help
2 2
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)

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:

[ ]
1
Q = bP 1− e
+ (1 − b ) E P ( )* 1− e 1− e (16)

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

b
a =
(
b + (1 −b ) E P * / P )
1−e (17)

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

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

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39