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Exchange rate pass-through, firm heterogeneity and product quality: a theoretical analysis

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  • Zhi Yu
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    Abstract

    This paper theoretically explores how exchange rate pass-through depends on firm heterogeneity in productivity and product differentiation in quality. Using an extended version of the Melitz and Ottaviano (2008) model, I show that exporting firms absorb exchange rate changes by adjusting both their markups and product quality, which leads to an incomplete exchange rate pass-through. Moreover, the absolute value of exchange rate absorption elasticity (the percentage change in the export prices denominated in the currency of the exporting country in response to a one percent change in the exchange rate rate) negatively depends on firm productivity for products with high scope for quality differentiation, but positively depends on firm productivity for products with low scope for quality differentiation.

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    File URL: http://www.dallasfed.org/assets/documents/institute/wpapers/2013/0141.pdf
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    Paper provided by Federal Reserve Bank of Dallas in its series Globalization and Monetary Policy Institute Working Paper with number 141.

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    Date of creation: 2013
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    Handle: RePEc:fip:feddgw:141

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    Keywords: Trade ; Markets;

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    1. Pinelopi Koujianou Goldberg & Michael M. Knetter, 1997. "Goods Prices and Exchange Rates: What Have We Learned?," Journal of Economic Literature, American Economic Association, vol. 35(3), pages 1243-1272, September.
    2. Rauch, James E., 1999. "Networks versus markets in international trade," Journal of International Economics, Elsevier, Elsevier, vol. 48(1), pages 7-35, June.
    3. Bernard, Andrew B. & Jensen, J. Bradford & Schott, Peter K., 2006. "Trade costs, firms and productivity," Journal of Monetary Economics, Elsevier, Elsevier, vol. 53(5), pages 917-937, July.
    4. Pinelopi K. Goldberg & Rebecca Hellerstein, 2007. "A framework for identifying the sources of local currency price stability with an empirical application," Staff Reports, Federal Reserve Bank of New York 287, Federal Reserve Bank of New York.
    5. Dornbusch, Rudiger, 1987. "Exchange Rates and Prices," American Economic Review, American Economic Association, American Economic Association, vol. 77(1), pages 93-106, March.
    6. Marc J. Melitz & Gianmarco I.P. Ottaviano, 2005. "Market Size, Trade, and Productivity," NBER Working Papers 11393, National Bureau of Economic Research, Inc.
    7. Benjamin R. Mandel, 2010. "Heterogeneous firms and import quality: evidence from transaction-level prices," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 991, Board of Governors of the Federal Reserve System (U.S.).
    8. Antoine Gervais, 2013. "Product Quality and Firm Heterogeneity in International Trade," Working Papers 13-08, Center for Economic Studies, U.S. Census Bureau.
    9. Menon, Jayant, 1996. "The Degree and Determinants of Exchange Rate Pass-through: Market Structure, Non-tariff Barriers and Multinational Corporations," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 106(435), pages 434-44, March.
    10. Dramane Coulibaly & Hubert Kempf, 2010. "Does Inflation Targeting decrease Exchange Rate Pass-through in Emerging Countries ?," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00497446, HAL.
    11. Lourdes Martín & Diego Rodríguez, 2004. "Pricing to market at firm level," Review of World Economics (Weltwirtschaftliches Archiv), Springer, Springer, vol. 140(2), pages 302-320, June.
    12. Roberts, Mark J & Tybout, James R, 1997. "The Decision to Export in Colombia: An Empirical Model of Entry with Sunk Costs," American Economic Review, American Economic Association, American Economic Association, vol. 87(4), pages 545-64, September.
    13. Gita Gopinath & Oleg Itskhoki, 2010. "Frequency of Price Adjustment and Pass-Through," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 125(2), pages 675-727, May.
    14. Barhoumi, Karim, 2006. "Differences in long run exchange rate pass-through into import prices in developing countries: An empirical investigation," Economic Modelling, Elsevier, Elsevier, vol. 23(6), pages 926-951, December.
    15. Coulibaly, D. & Kempf, H., 2010. "Does Inflation Targeting decrease Exchange Rate Pass-through in Emerging Countries?," Working papers, Banque de France 303, Banque de France.
    16. Giovannini, Alberto, 1988. "Exchange rates and traded goods prices," Journal of International Economics, Elsevier, Elsevier, vol. 24(1-2), pages 45-68, February.
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