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Exchange Rate Pass-through in a Small Open Economy: the Importance of the Distribution Sector

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  • Pål Boug

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  • Ådne Cappelen
  • Torbjørn Eika
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    Abstract

    The degree of exchange rate pass-through to domestic goods prices has important implications for monetary policy in small open economies with floating exchange rates. Evidence indicates that pass-through is faster to import prices than to consumer prices. Price setting behaviour in the distribution sector is suggested as one important explanation. If distribution costs and trade margins are important price components of imported consumer goods, adjustment of import prices and consumer prices to exchange rate movements may differ. We present evidence on these issues for Norway by estimating a cointegrated VAR model for the pricing behaviour in the distribution sector, paying particular attention to exchange rate channels likely to operate through trade margins. Embedding this model into a large scale macroeconometric model of the Norwegian economy, which inter alia includes the pricing-to-market hypothesis and price-wage and wage-wage spirals between industries, we find exchange rate pass-through to be quite rapid to import prices and fairly slow to consumer prices. We show the importance of the pricing behaviour in the distribution sector in that trade margins act as cushions to exchange rate fluctuations, thereby delaying pass-through significantly to consumer prices. A forecasting exercise demonstrates that exchange rate pass-through to trade margins has not changed in the wake of the financial crises and the switch to inflation targeting. We also find significant inflationary effects of exchange rate changes even in the short run, an insight important for inflation targeting central banks. Copyright Springer Science+Business Media New York 2013

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    Bibliographic Info

    Article provided by Springer in its journal Open Economies Review.

    Volume (Year): 24 (2013)
    Issue (Month): 5 (November)
    Pages: 853-879

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    Handle: RePEc:kap:openec:v:24:y:2013:i:5:p:853-879

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    Web page: http://www.springerlink.com/link.asp?id=100323

    Related research

    Keywords: Exchange rate pass-through; Pricing behaviour; The distribution sector; Econometric modelling and macroeconomic analysis; C51; C52; E31; F31;

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    References

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    1. Svensson, Lars E.O., 1998. "Open-Economy Inflation Targeting," Seminar Papers 638, Stockholm University, Institute for International Economic Studies.
    2. Naug, Bjorn & Nymoen, Ragnar, 1996. " Pricing to Market in a Small Open Economy," Scandinavian Journal of Economics, Wiley Blackwell, vol. 98(3), pages 329-50.
    3. P�l Boug & Andreas Fagereng, 2010. "Exchange rate volatility and export performance: a cointegrated VAR approach," Applied Economics, Taylor & Francis Journals, vol. 42(7), pages 851-864.
    4. Burstein, Ariel T. & Neves, Joao C. & Rebelo, Sergio, 2003. "Distribution costs and real exchange rate dynamics during exchange-rate-based stabilizations," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1189-1214, September.
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    7. Anders Rahbek & Rocco Mosconi, 1999. "Cointegration rank inference with stationary regressors in VAR models," Econometrics Journal, Royal Economic Society, vol. 2(1), pages 76-91.
    8. Jurgen A. Doornik, 1998. "Approximations To The Asymptotic Distributions Of Cointegration Tests," Journal of Economic Surveys, Wiley Blackwell, vol. 12(5), pages 573-593, December.
    9. Håvard Hungnes, 2008. "A Demand System for Input Factors when there are Technological Changes in Production," Discussion Papers 556, Research Department of Statistics Norway.
    10. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
    11. Chen, Yu-chin & Rogoff, Kenneth, 2003. "Commodity currencies," Journal of International Economics, Elsevier, vol. 60(1), pages 133-160, May.
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