Exchange Rate Pass-Through, Domestic Competition and Inflation: Evidence from the 2005/08 Revaluation of the Renminbi

Abstract

How important is the effect of exchange rate fluctuations on the competitive environment faced by domestic firms and the prices they charge?To answer this question, this paper examines the 17% appreciation of the yuan against the US dollar from 2005 to 2008.In a monthly panel covering 110 sectors, a 1% appreciation of the Yuan increases US import prices by roughly 0.8%.It is then shown that import prices, in turn, pass through into producer prices at an average rate of roughly 0.7, implying that a 1% Yuan appreciation increases the average US producer price of tradable goods by 0.8%*0.7=0.56%.In contrast, exchange rate movements of other trade partners have much smaller effects on import prices and hardly any effect on producer prices.The paper next demonstrates that the pass through response into import prices is heterogeneous across sectors with different characteristics such as traded-input intensity or the shape of demand for the sector's goods.In contrast, the rate at which import prices pass through into domestic producer prices is found to be homogenous across the sectors.Finally, the insights of the analysis are employed to simulate the inflationary effect of a Yuan revaluation.For example, the relative price shock caused by a 25% appreciation of the Yuan spread evenly over 10 months is equivalent to a temporary increase of the US PPI inflation rate by over five percentage points.Because such an appreciation would also influence the overall skewness of the distribution of price changes at the sectoral level, it would likely also impact U.S. equilibrium inflation.

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