Exchange-Rate Pass Through

Exchange rates have a seemingly direct effect on the price of imports and exports. The concept of the pass-through effect relates to the degree by which a currency fluctuates and the impact this has on import and export prices in the market. Exchange rate pass-through refers to the percent change in the exchange rate between the exporting and importing countries. The degree to which different currencies fluctuate against each other and against various imports and exports is an entirely different argument relating to a wide variety of variables, such as, market share, the strength of a currency, and how dependent the markets are on trade with a given country.
Some general economic influences of pass-through can be explained with a simple supply-demand model where the law of one price holds. There can, however, be cross-country variations in pass-through exchange rate fluctuations to domestic prices. “In a large country, the inflationary effect of a currency depreciation on domestic prices is counteracted by a decline in the world price (because of lower world demand), reducing measured pass-through. For a small country, currency depreciation would have no effect on world prices, and thus pass-through would be complete in the simple model. Therefore, even within the conies of this model, pass-through should be greater in smaller economies.” (McCarthy, 2000) The simple model, however, does not always prove to be true across countries, time, and across industries within a country. There has been a recent focus on firm-specific adjustments of markups to changes in the various countries exchange rates. It has been noted that the pass-through effect to import prices is smaller in more concentrated, segmented industry. From a cross-country comparison, this means that a specific countries’ share of imports in a given sector is a fair representation of the import penetration faced by firms; meaning, import prices are more directly tied to domestic prices. When