Exchange Rate Pass-Through
Definition of exchange rate pass-through
Exchange rate pass-through is an economic concept and is defined as the change in percent of import prices in local currency as a result of change in exchange rate of the importing and exporting countries. When the exchange rates fluctuate, the costs of imports also change and this often has an impact on the prices of retail products as well as consumer prices. This is the reason why exchange rate pass-through has also been defined as the change in consumer price index (CPI) as a result of changes in the exchange rates of different trading countries.
Factors affecting exchange rate pass-through
Factors that affect exchange rate pass-through continue to elicit strong debate. This is because the concept is very broad hence many approaches are taken to determine the whole issue. Amongst key issues that can lead to change in imports as a result of escalation or decline in exchange rate include:
- The currency choice.The type of currency that is used in determining the prices of products always influences exchange rate pass-through or lack of it. For instance, countries which use standard currencies such as the euro or dollar for trading purposes may experience less volatilities and changes in exchange rates. This may reduce the cases of exchange rate pass-through.
- The models of determining price.Basically economists widely debate over the local currency pricing (LCP) and the producer currency pricing (PCP). Under LCP fixed exchange rates are preferred hence changes in the exchange rate may have very little impact on the prices of imports. Prices of products in this case react strongly with international variables because of the outward focused monetary policies used. On the other hand, PCP is the opposite of LCP because in this case producers determine the price of products. This makes the exchange rates more flexible and import prices are less affected by international variables. The monetary policies in this case tend to be focused inward.
- Government policies.The macroeconomic policies regarding trade and in particular imports can determine the exchange rate pass-through in an open economy.
Impact of exchange rate pass-through
Exchange rate pass-through always has an impact on trade. Imports in particular get affected by the changes in exchange rates.
Exchange rate pass-through can help countries with strong currencies because they can determine the world prices and export to other countries that are just price takers can benefit from this concept especially if they sell more products at better profits,
Countries that are net importers can be very vulnerable to exchange rate pass-through. For such countries, a percentage rise in the cost of imports can have dire economic consequences because the countries might have to spend much more. This situation can be further exacerbated if the product involved is food.
A rise in the consumer price index can hurt consumers in domestic markets especially in cases where the source of income for consumers is stagnant while the prices of different products continues to rise. This can render them unable to afford essential commodities.
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