Through Exchange rate pass through is the degree of sensitivity of various import prices to a one percent change in exchange rates, in the importing countrys currency. It is a financial term that is closely related to Pricing to Market , a term used to refer to the behavior of different firms that export their products to a specific market for a change in exchange rate.
The two are closely related and when there is a high degree of PTM, the exchange rate pass through will be lower. However, if the prices of imports change by the same proportion in exchange rate, there will be complete exchange rate pass through and no pricing to market.
Exporters can also adjust the prices of their exports and their own currency in the same proportion of exchange rate change resulting in full pricing to market. In this case, there will be a zero exchange rate pass through.
Factors that determine exchange rate pass through
There are different factors that determine exchange rate pass through including, the degree of competition between exporters in a market and the size of the market. If the market is large, exporters are often willing to get a large share of the exchange rate to maintain their market share. This is highly competitive and it offers consumers many choices on which exporter to settle for.
The magnitude and direction of exchange rate also affects exchange rate pass through. Exporters are always willing to absorb exchange rate change if the market destination of currency depreciates. It helps them to maintain their market share. However, with a strong currency market, exporter products or goods will be available at a cheaper price. This means that the response of exporters will be asymmetric.
A countrys exchange rate and monetary policies also determine the exchange rate pass through. Countries with lower inflation rate and a strong monetary policy lower the extent of exchange rate pass through.
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Exchange rate pass through is also determined by consumer currency pricing. Exchange rates will change if the exports of an importing nation are invoiced in its currency. This is based on the fact that the change will have a little or no impact on market import prices.
Cross border production fragmentation also affects exchange rate pass through. If a country exports a final product and imports its components or corresponding parts from another country, it will experience depreciation. The exchange rate will affect the exporters costs leading to a low exchange rate changes due to increased competition and dispersion of production processes.
Low exchange rate-pass through
Low exchange rate pass through has a great impact on import prices compared to that on consumer price index. This is because consumer price index includes less responsive non-tradable. Irrespective of the price index used, exchange rate pass through was low in 1990s. Recent studies show that the trend is same in developing and developed countries.
With many factors that determine exchange rate pass through, macroeconomic factors lower the rate of inflation. Additionally, lower variables in exchange rate will also translate to lower exchange rate pass through. This means that the exchange rates have a great impact on microeconomic phenomenon depending on the type of goods being traded.
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