Exchange Rate Pass Through Analysis

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What do we know about the exchange rate pass‐through?

Throughout history, there has been significant debate within international economic literature over fixed and flexible exchange rate regimes. Presently, Australia uses a flexible exchange rate system and argues that this would allow a more efficient system of international adjustments to occur. However, academics have identified that foreign exchange rate markets, under flexible regimes, are vulnerable to a significant amount of volatility. Due to this erratic volatility, academics have sought to develop an explanation for these adjustments – this eventually became to what is known as the exchange rate pass-through. This is a measure of how responsive international prices are to changes
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Academic research, which has traditionally assumed prices respond proportionally to changes in costs induced by exchange rates, has revealed that the pass through may not be ‘complete’ (Gron 1996). This implies that changes in the exchange rate may cause a smaller change in the price of imported goods than the percentage change in the exporting country’s exchange rate. In the paper ‘Currency Choice and Exchange Rate Pass-through’, Gopinath stated a possible reason for this incomplete pass-through is that international market are extremely segmented. She purported that this market imperfection would allow competitive firms to be able to charge different prices for the same product across multiple …show more content…
The more pronounced is the exchange rate pass through is. It is quite intuitive why the short and long term pass through exchange rate is influenced by the fraction of flexible price firms (Goldberg 2008). This is because they are the only type of firms/businesses that will update their prices in response to a real exchange rate movement. Hence, if there was a phenomenon that causes a decrease in the fraction of flexible-priced firms in Australia, this should cause a fall in the exchange rate pass through. The reasoning behind this fall is that only flexible price firms have the capacity and ability to incorporate information about current exchange rates shocks when setting prices for their goods. Similarly, the hypothetical decline in the exchange rate pass-through can also be caused at the individual firm level. Since flexible priced firms are able to change their product prices in response to changes in the exchange rate, if these firms become less responsive to changing exchange rates, their response to prices will be reduced. Thus, when the responsiveness of an individual firm decreases, a real exchange rate change will have a lesser impact on the firms’ desire to change prices – hence reducing the exchange rate pass

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