694 Panel Methods to Test for Unit Roots and Cointegration
The industrial organization literature offers explanations for why the effect of the
change inertonmptmay differ from one (with typically less than full pass-through,
where the latter is defined as pass-through equal to one), using determinants of
the mark-up such as competitive conditions among exporters in the destination
markets. Mark-up responsiveness depends on the market share of domestic pro-
ducers relative to foreign producers, the form of competition that takes place in
the market for the industry, and the extent of price discrimination. Other factors
affecting pass-through are the currency denomination of exports and the structure
and importance of intermediate goods markets.
For example, the empirical set-up of CGM is based on assuming unity translation
of exchange rate movements. If pass-through is complete (for example, in the case
of producer currency pricing), and the mark-ups of producers do not fluctuate in
response to fluctuations of the exchange rates, this leads to a pure currency trans-
lation. At the other extreme, the exporter can decide not to vary the prices in the
destination country currency (local currency pricing) and absorb the fluctuations
within the mark-up. Thus, mark-ups in an industry are assumed to consist of a
component specific to the type of good, independent of the exchange rate, and a
reaction to exchange rate movements:
fmkupt=a+#ert.It is also important to consider effects working through the marginal cost. These are
a function of demand conditions in the importing country, denotedyt; marginal
costs of production in the exporting country (labor wages in domestic currency),
denotedfwt; and commodity prices denominated in foreign currency,fcpt:
fmct=coyt+c 1 fwt+c 2 ert+c 3 fcpt.We therefore have:
mpt=a+( 1 +#+c 2 )ert+c 0 yt+c 1 fwt+c 3 fcpt+εtwhere the coefficientb≡( 1 +#+c 2 )on the exchange rateertis the pass-through
elasticity andεtis a stochastic error term. In the CGM “integrated world market”
specification,c 0 yt+c 1 fwt+c 3 fcptis independent of the exchange rate. It is called
the opportunity cost of allocating those same goods to other customers and is
reflected in the world price of the productfptin the world currency (here taken to
be the US dollar). Thus the final pass-through equation can be rewritten as follows:
mpt=a+bert+cfpt+εt,which gives the long-run relation between the import price, exchange rate and a
measure of foreign price.
Testing for ERPT
Both economic theory and relevant tests lead us to think of each of the series
(import price, exchange rate and world price) as being characterized by a unit root.