Anindya Banerjee and Martin Wagner 693to the domestic market in the face of exchange rate fluctuations (say, relative to
the dollar if foreign prices are denominated in dollars) and pricing strategies of
the exporters in the foreign countries. Studies of ERPT have been conducted both
for the United States and for countries of the euro-area to study the importance of
institutional arrangements (such as the inauguration of the euro-area) in generating
responses to exchange rate institutions and changes.
An important feature missing from the discussion is a connection between the
theoretical arguments surrounding the key determinants of pass-through, and the
inappropriate techniques used to estimate equations measuring import or export
exchange rate pass-through. For example, while almost all the theories contain a
long-run or steady-state relationship in the levels of a measure of import unit values
(in domestic currency), the exchange rate (relating the domestic to the numeraire
currency) and a measure of foreign prices (unit values in the numeraire currency,
typically US dollars), this long-run relationship is routinely disregarded in most of
the empirical implementations.
Since there is substantial consensus in the literature that the time series being
studied are integrated variables, one way of defining the long run is in the sense of
Engle and Granger (1987) (henceforth EG), where it is given by the cointegrating
relationship. A reason often given for ignoring this long-run relationship, and
substituting it by anad hocmeasure, is a failure to find evidence for cointegration
in the data. We argue that a more satisfactory approach is to look for the long-
run relationship using more appropriate and powerful methods, such as those
which allow for changes in the long-run or use more powerful panel data methods.
In doing so, it is also important to allow for breaks in the long-run theoretical
relationship so as to take due account of potential changes in pass-through rates
in response to changes in financial regimes, such as the introduction of the euro
in January 1999.
Exchange rate pass-through into import prices
By definition, import prices for any countryiand type of goodj,MPti,j, are a
transformation of the export prices of a country’s trading partners,XPti,j, using the
bilateral exchange rateERt(say with respect to the dollar, if prices are denominated
in dollars). Thus dropping superscriptsi,jfor clarity:
MPt=ERt×XPt.In logarithms (depicted in lower case):
mpt=ert+xpt.If the export price consists of the exporters marginal cost and a mark-up:
XPt=FMCt×FMKUPt,we have, in logarithms, by substituting forxpt:
mpt=ert+fmct+fmkupt.