# **PASS-THROUGH OF COMPETITORS’ EXCHANGE RATES TO US IMPORT AND PRODUCER PRICES***

STEVEN PENNINGS

# 1. Introduction

Standard empirical and theoretical models focus on the bilateral exchange rate (between exporting and importing countries) as the key international macroeconomic variable determining prices. However, since the 1980s (e.g. Dornbusch 1987) it has been appreciated that competitors’ prices will be an important determinant of international prices in models where firms price strategically. In this paper, I extend the literature to show that in a multi-country (>2) world, this general class of model (where markups depend on other firms’ prices) implies that US import prices and producer prices will respond to the exchange rates of the producer’s foreign competitors (Section 2). Using US microdata at the product level, I show that pass-through of competitors’ exchange rates to import prices is large — often larger than pass-through of the bilateral exchange rate — and that US producer prices also respond significantly to competitors’ exchange rates (Section 3). Consistent with this mechanism, pass-through of foreign competitors’ prices is sizable. I develop a multi-country extension of the model of Atkeson and Burstein (2008) (henceforth AB), which is able to explain a large share of pass-through of competitors’ exchange rates when regressions are run on simulated data (Sections 4 and 5). While some of these facts for import prices have been mentioned briefly elsewhere (e.g. Gopinath and Itskhoki 2011, henceforth GI2011), this paper is among the first to analyze them systematically.

**An example** To fix ideas, consider four car producers from the US, Europe, Japan and Canada competing in the US market. Standard bilateral exchange rate pass-through suggests that a real appreciation of the yen against the USD will raise the real price of Japanese cars imported into the US. However, models of strategic pricing also predict that the Japanese car producer will respond to the prices — and hence exchange rates — of its foreign competitors (from Europe, Canada, etc). That is, a real appreciation of the euro or Canadian dollar will lead the Japanese car producer to raise its prices in the US, even if the real bilateral yen-USD exchange rate is unchanged.

Figure 1 illustrates these patterns in the aggregate data for real import prices from Japan, Europe and Canada. On the left is the standard relationship in the literature between import prices (y-axis) and bilateral real exchange rates (RERs) (x-axis). On the right is the new relationship between the same import prices (y-axis) and competitors’ RERs (x-axis) at the aggregate level, which turns out to be at least as strong. I show that similar patterns hold at the product level using Bureau of Labor Statistics (BLS) microdata. Quantitatively, standard univariate bilateral pass-through to import prices is around 0.23 in both the BLS microdata and in the aggregate (Figure 1 LHS) compared with pass-through of competitors’ RERs to import prices of around 0.35 in the BLS microdata (after controlling for bilateral RERs).<sup>1</sup> This is consistent with Date: November 2016.

> * Development Research Group, World Bank, 1818 H St NW, Washington DC 20433 USA Email: spennings@worldbank.org I would like to thank Ariel Burstein, Virgiliu Midrigan, Raphael Schoenle, Pete Klenow, Jonathan Kearns, Emi Nakamura, Jon Steinsson, and seminar participants at the World Bank, May 2012 Midwest Macro Meetings, NYU, the Reserve Bank of Australia, and the Bureau of Labor Statistics (BLS) for helpful comments. This research was conducted with restricted access to BLS data on US import and producer prices. The findings, interpretations, and conclusions expressed in this work are those of the author’s and do not necessarily reflect the views of the BLS or the World Bank (or its Board of Directors, or the governments they represent). I thank my BLS project coordinators, Rozi Ulics, Kelley Khatchadourian and Ryan Ogden, for assistance throughout the project.

> 1In the aggregate data in Figure 1, pass-though of competitors’ RERs to import prices is about 0.32 (t = 4) in a simple univariate regression. After controlling for bilateral RERs (as I do the BLS microdata), aggregate pass-through of competitors’ RERs falls to about 0.19 (t = 2.5) (see partial scatter plot in the online appendix). However, controlling for competitors’ RER’s also reduces aggregate bilateral PT to 0.195 (t = 5) (not reported). In the aggregate data, competitors’ RERs are approximated

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