Incomplete Pass-through in Import Markets and Permanent versus Transitory Exchange-rate Shocks

This paper investigates the price-setting behavior of suppliers of imports. The ad-hoc estimation of error-correction models for the U.S., Japan, Germany, France, and Italy indicates that changes in the real exchange rate are not fully passed through into import prices, not even in the long run. By modeling the dynamic behavior of import suppliers as an inter-temporal optimization problem with adjustment costs it can be shown, however, that the degree of long-run pass-through might be underestimated if one does not properly distinguish between permanent and transitory exchange rate changes. Therefore, a Blanchard-Quah decomposition is used to identify the permanent and the transitory component of the exchange rate from its joint process with the current account. Reestimation with this additional piece of information yields substantially higher degrees of pass-through in the long run as well as in the short run. Thus, a proper distinction might be crucial when predicting import price responses to exchange rate changes.