Exchange Rate Passthrough: Theory | Summary and Q&A

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September 28, 2020
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Stanford Graduate School of Business
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Exchange Rate Passthrough: Theory

TL;DR

Exchange rate pass through refers to the extent to which changes in exchange rates affect the prices of goods in different countries.

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Questions & Answers

Q: What is the real exchange rate and how is it calculated?

The real exchange rate is the relative price of a basket of goods in one country compared to another, after converting it into a common currency. It can be calculated as the price in the home country divided by the price level in the foreign country, multiplied by the exchange rate.

Q: Why is the traded sector important when analyzing exchange rate pass through?

The traded sector is where the law of one price is most likely to hold, making it a natural place to study how prices vary across countries. It is also where arbitrage would be an important disciplining force, suggesting that the purchasing power parity theory would hold.

Q: Why are exchange rate pass through estimates often lower than one?

Despite the theory suggesting that exchange rate pass through should be complete (equal to one), empirical studies have found that it is often incomplete. This could be due to factors such as variable markups and variable marginal costs, as well as price stickiness and other dynamic effects.

Q: How does exchange rate pass through impact inflation dynamics?

Exchange rate movements can influence a country's inflation dynamics. Understanding the extent of pass through is crucial for predicting how changes in exchange rates will affect a country's inflation rate.

Summary & Key Takeaways

  • The real exchange rate is the relative price of a basket of goods in one country compared to another, after translating it into a common currency.

  • Basic theories suggest that the real exchange rate can be divided into a traded sector and a non-traded sector, with the law of one price likely to hold in the traded sector.

  • Empirical analyses have shown that exchange rate pass through into import prices is often incomplete, with recent studies finding low pass through rates.

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