Exchange Rate Economics: Theories and Evidence

84 The economics of the PPP puzzle
In order to address the relative importance of menu costs and pricing to market in
explaining imperfect pass-through,Ghosh and Wolf (2001) examine the properties
of the prices of the Economist and Business Week using a panel of 11 countries for
the period January 1973 to December 1995 (the Economist) and January 1980
to December 1995 (for Business Week). Their analysis of this data set reveals the
following. First,they find a small pass through from contemporaneous exchange
rates to prices (3% and 11% for the Economist and Business Week,respectively).
Second,they find a much larger pass through of cumulative exchange rate changes
since the last price adjustment to the current price change. Third,the pass through
elasticity increases sharply if the sample is restricted to those months in which prices
are changed,although the elasticity is well below unity. The conclusions Gosh and
Wolf draw from this evidence is that menu costs play an important role in addition
to strategic pricing decisions.
Goldberg and Knetter (1997) provide a useful survey of the degree of exchange
rate pass-through and note a consensus estimate of the pass-through from the
exchange rate to import prices for the US of 60%,although lower-long run estimates
for the US are suggested in Campa and Goldberg (2002) (approximately
30% pass-through for the US). Campa and Goldberg (2002) report pass-through
percentages of 40% and 80%,respectively,for Germany and Japan. 5
Feenstra and Kendall (1997) use quarterly data over the period 1974:1 1994:4
to test equations (3.23) and (3.24) for the bilateral (home currency to) US dollar
exchange rates of Canada,Germany,Japan and UK. In order to operationalise
these expressions,they take a log-linear specification of the two demand functions
(defined in exporters and importers currency) and by aggregating them and
exploiting the covered interest parity condition they obtain:
ln s t = β 0 + (ln ct ∗ − ln l t ) − β 1 [λ(ln P t − ln l t ) + (1 − λ)
× (ln Pt ∗ − ln ct ∗ )]+(i t − it ∗ ) + β 3u t (3.27)
where the exchange rate is the foreign currency price of the dollar (the dollar being
the home currency c ∗ denotes marginal and average costs in the foreign currency
(measured using the foreign currency WPI) l is the price of import-competing
goods (taken as the US WPI), P and P ∗ denote the import and export price indices,
respectively and the term in square brackets has the interpretation of an average
traded price,the interest differential is the 90-day interest differential and the β’s
are reduced form parameters.
The Johansen multivariate cointegration method is used to test for evidence of
long-run relationships amongst the variables entering (3.27) and evidence of three
significant cointegrating vectors is found in each case (although in some cases
this finding is ambiguous). For each country,the first vector is normalised on the
exchange rate and the coefficients on the relative WPI term (which is essentially
the PPP term in this relationship) are all statistically significant and close to their
hypothesised values of +/−1 for the UK,Canada and Japan but far away for
Germany (in the majority of cases the coefficients are also insignificantly different
from unity). The coefficient on the average traded price turns out to be highly