One of the most studied issues in international economics is the exchange rate pass-through, which is the effect of fluctuations in exchange rates on export/import prices. Since exporters/importers have costs and revenues in different currencies, any exchange rate movement or delay in repricing affects markups directly. Therefore, a proper understanding of this phenomenon requires to focus on the optimal pricing policy of international traders. How firms set prices determine the degree and the dynamics of the exchange rate pass-through.
The degree and timing of exchange rate pass-through is crucial to policy makers. In fact, the optimal exchange rate regime and the transmission channels of international shocks are totally related to how exporters/importers react to exchange rate movements. For instance, the common wisdom that a devaluation boosts the export sector (expenditure switching effect) disappears completely if international traders set prices in their consumers’ currency.
The exchange rate pass-through literature strongly supports two stylized facts: an incomplete degree of pass-through, and a persistent delay in the price response. The first fact emphasizes a heterogenous degree of pass-through with a usually complete exchange rate pass-through in commodities, but an incomplete pass-through especially in manufactured sectors. The second fact highlights the slow adjustment of prices after movements in the relevant exchange rates. Reduced form estimates usually identify “short-run” and “long-run” pass-through coefficients, stressing a delay in price responses.
These two stylized facts have had a deep impact on the field. The fist fact ruled out models of perfect competition, since the incomplete pass-through contradicts a constant markup. The persistent incomplete pass-through is consistent with “pricing to market” behavior, as coined by Krugman (1987). Pricing to market essentially allows for price discrimination based on the currency, and the market where the transaction takes place. This behavior requires segmented markets and imperfect substitution, such as in differentiated products. The second stylized fact challenges how to address dynamic pricing since delays in response may deviate the price from their optimum. Most empirical research has focused on time series and panel data reduced forms to capture co-movements that can shed light on the underlying mechanisms of firm’s behavior.
To have a deeper understanding, a new empirical literature has moved from reduced forms to structural estimation. This econometric approach allow us to identify parameters that have a clear root in the microeconomic foundations of the respective model. Goldberg (1995), Verboven (1996), Golberg and Verboven (2001) and Goldberg and Hellerstein (2008) have estimated structural parameters using the setting of differentiated products. So far, most of the structural estimations in this topic has only considered firms in a repeated static framework. A static setting can not fully address the pass-through delay already mentioned. A remarkable attempt of including dynamic considerations is done by Emi Nakamura and Dawit Zerom (2008), who solve a fully dynamic model for the coffee industry. However, they are only able to estimate the dynamic model under quite restrictive assumptions regarding the form of marginal costs. My framework allows me greater flexibility in estimating the model.
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