Prices of imported goods are greatly affected by a currency exchange rate regime, as well as the monetary policy in place and the link between exchange rate movements and import prices. Recent debates hinge on whether producer-currency-pricing (PCP) or local currency pricing (LCP) of imports is more predominant, and on whether exchange rate “pass-through” rates are endogenous to a country's macroeconomic conditions.
A significant issue for industry competitiveness is the degree to which exchange rate changes affect the prices of imported goods. Many researchers have focused on the issue of domestic consumer price index (CPI) and its relationship to currency exchange rates and how importers “pass through” changes in exchange rates to prices. This makes the exchange rate a consequence of domestic inflation and very important when considering monetary policy. The theoretical framework shows that there are four factors determining the axis of exchange rate pass-through: the openness of the economy, flexibility between price-firms in the economy, the reliability of the central bank, and the amount of exchange rate fluctuation “pass through” at the level of the producer-firm. The practical result is that the foreign firm’s optimum price drops as the domestic currency appreciates, because appreciations of the domestic currency behaves like a reduction in the cost of production.
The problem of domestic firm pricing is comparable to that of the foreign firm, with one exception: the currency exchange rate has no role in the pricing decisions of the domestic firm, as all costs of production are sustained in the domestic economy.
Exchange rate “pass-through” studies consider the extent to which exchange rate movements are added into imported merchandise prices or in contrast, a reduction in producer profit margins or markups. Recent studies indicate a “pass through” average of imported prices as 0.61 in the short-run and 0.77 in the long-run for the OECD country group.
The standard assumption of price behavior is that markets are imperfectly competitive, where most businesses have some power to set prices. It follows the model assumption that the average business sets a unit price (P) and a mark-up (M) over the unit labor cost in production measured at a fixed rate of capacity utilization use of plant and equipment adding only the unit materials cost. This standard business procedure takes on the analysis of the Phillips curve. This concept was developed by A. W. Phillips showing that inflation and unemployment have a stable and inverse relationship. However, in recent years there has been a new Keynesian interpretation explaining the breakdown of the simple Phillips curve in terms of the Non-Accelerating Inflation Rate of Unemployment (NAIRU).
This exists at the Short Run Phillips Curve, as the rate of unemployment at which inflation will stabilize or that this rate of unemployment, prices will raise at the same rate each year
An alternative explanation for changes in exchange rate “pass-through” aggregate import prices can be related to the composition of a country’s imports. Pass through elasticity is different across types of imports, and these changes could deliver variations in the “pass through” elasticity to the aggregate import prices.
According to the US International Trade Commission around 90% of U.S. imports in the Bills of Lading sampled for data analysis report prices in US dollars. This fraction however varies by country of origin. The fraction of imports in the exporter’s currency is, for example, 34% from Germany, 16% from U.K. and 13% from Japan.
As is well known, a significant fraction of trade takes place inter-firm. This database analysis allows the identification of transactions taking place with inter-firm transactions excluded. Test-theories of prices that are driven mainly by market forces exclude inter-firm prices from analysis.
Currency Arbitrage
A foreign exchange strategy takes place when a currency trader profits from the different spreads offered by brokers of a particular currency-pair that are being offered for trade. There are many spreads in a currency-pair market which imply disparities between the bids and ask prices. Buying and selling currency pairs from different brokers in order to profit from currency disparity involves what is known as currency arbitrage.
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