Exchange Rate Economics: Theories and Evidence

78 The economics of the PPP puzzle
say,what explains price stabilisation in the local currency (or relatedly the degree of
pass-through)? A number of hypotheses have been given in the literature to explain
this phenomenon. Among them are imperfect competition,costs of adjustment in
supply,menu costs,concern for market share and the role of particular currencies
in the international financial system. In terms of the latter,if the price which
is used to invoice an export is the home currency then exchange rate fluctuations
will not affect the home currency price and there will be zero pass-through from the
exchange rate to domestic prices. Since so many traded goods are invoiced in terms
of US dollars,perhaps the US is the best example of a country where LCP is likely to
be effective. However,for countries whose currencies are not widely used for invoicing
purposes,pricing to market (PTM) (a term introduced by Krugman (1987))
the existence of differentiated products and imperfectly competitive firms,who
price discriminate across export markets,can also generate a stabilisation of local
currency prices and zero pass through. For example,such firms may alter the
mark-up of price over marginal cost as the exchange rate changes in order to protect
their market share in a particular location. However,it is worth noting that the
alternative paradigm of a perfectly competitive firm structure can also generate this
result. For example,say there is an appreciation of a country’s currency and this
appreciation is correlated with a rise in world demand,which pulls up marginal
costs. In this case pass through would also be less than complete (i.e. the tendency
for the local currency price to fall as the exchange rate appreciated would be offset
by the rising marginal cost).
3.3.2 Pricing to market: theory
The concept of PTM can be illustrated using the following simple partial equilibrium
model of exporter behaviour taken from Knetter (1989). An exporting
firm is assumed to sell to N foreign destinations and demand in each destination is
assumed to have the same general form:
x it = f i (s it p it )v it , i = 1, ..., N t = 1, ..., T ,(3.18)
where x it is the quantity demanded by destination market i in period t, p it is the price
in terms of the exporters currency, s is the exchange rate (foreign,or destination
currency,per unit of exporters currency) and v is a random (demand) shift variable.
The exporter’s costs are assumed to be given by:
(∑ )
C t = C xit δ t ,(3.19)
where C t measures costs in home currency units,the summation runs over all i
destination markets and δ t is a random variable that may shift the cost function –
due perhaps to a change in input prices. The period-t profit of the exporter is:
t = ∑ (∑ )
p it x it − C xit δ t . (3.20)