The Exchange Rate Disconnect

Why do large movements in exchange rates have small effects on international goods prices? This empirical regularity is a central puzzle in international macroeconomics. In a new study, we show that the key to understanding this exchange rate disconnect is to take into account that the largest exporters are also the largest importers. This is important because when exporters import their intermediate inputs, they face offsetting exchange rate effects on their marginal costs. For example, a depreciation of the euro relative to the U.S. dollar makes exports in U.S. dollars cheaper?but it also makes imports in euros more expensive. Using Belgian firm-level data, we show that exporters that import a large share of their inputs pass on a much smaller share of the exchange rate shock to export prices. Interestingly, import-intensive firms typically have high export market shares and hence set high markups and actively move them in response to changes in marginal cost, thus providing a second channel that limits the effect of exchange rate shocks on export prices. Our results show that a small exporter with no imported inputs has a nearly complete pass-through of more than 90 percent, while a firm at the 95th percentile of both import intensity and market share distributions has a pass-through of 56 percent, with the two mechanisms playing roughly equal roles. These findings have important implications for aggregate macroeconomic variables.