STEVEN PENNINGS 2 <!-- Start of picture text --> A. Pass−through of Bilateral RER to US Import Prices B. Pass−through of Competitors’ RER to US Import Prices<br>Imports from Canada, Euro Area, Japan (1990−2013) Imports from Canada, Euro Area, Japan (1990−2013)<br>Slope=0.32<br>Slope=0.23<br>−.2 −.1 0 .1 .2 −.2 −.1 0 .1 .2<br>Bilateral RER (annual change log) Competitors’ RER (annual change log)<br>Sources: FRED and BLS. See Appendix for details. Note: Comp RER is Real Broad TWI excl. bilateral RER. Sources: FRED, BLS. See Appendix.<br>.05 .05<br>0 0<br>−.05 −.05<br>Real Import Price (annual change log) Real Import Price (annual change log)<br>−.1 −.1<br><!-- End of picture text --> Figure 1. Aggregate-level pass-through of bilateral and competitors’ RERs to US import prices sizable pass-through of the trade weighted index (TWI) exchange rate to import prices as discussed briefly in GI2011. Pass-through of competitors’ RERs to US producer prices is around 0.1 in the BLS microdata.<sup>2</sup>

**Model** To compare the quantitative size of these forces in theory and data, I develop a multi-country extension of AB where (i) goods are more substitutable within than between sectors, and (ii) the small number of firms in each sector engage in Cournot competition. A linearized version of the firm’s pricing equation has the same form as the general class of models discussed above: firms respond to competitors’ prices. Solving for those prices generates a linear “structural pass-through” representation where the firm’s price responds to its own bilateral exchange rate and the exchange rates of its foreign competitors. The mechanism in the model suggests that firms face a changing elasticity of demand as their market share changes, and as a result, firms will adjust their prices to maintain their market share. For instance, in the previous example, a real appreciation of the Canadian dollar leads Canadian manufacturers to charge higher prices in the US, and so the manufacturer from Japan will raise its price to maintain its market share. The model also predicts that US producers will respond to the prices of their competitors.

Quantitatively, the model is able to explain a bit less than half of pass-through of competitors’ exchange rates to import prices in the data (0.35 in the data, vs 0.15 in the model) and almost all of pass-through to producer prices (0.11 in the data vs 0.09 in the model). This is a substantial improvement on most models in the literature which have no role for foreign competitors’ exchange rates.

However, one weakness of the baseline model (and others in the literature) is that it over-predicts bilateral pass-though – univariate bilateral pass-through is around 0.23 in the data vs 0.65 in the baseline model (without imported intermediates), or around 0.5 with imported intermediates (as an extension). This class of model also fails to match the combination of low short-run and high long-run price elasticities of trade (the “elasticity puzzle”) in Drozd and Nosal (2012b). Drozd and Nosal (2012a) are able to match both but focus on explaining aggregate prices, rather than micro-level prices as I attempt to do here.

**Imported Intermediates** An alternative explanation of the empirical results is that intermediate goods are imported from third countries, which naturally makes the prices of final goods sensitive to third-country exchange rates, even if markups are (relatively) fixed. Amiti et al (2014, 2016) find that prices of imported inputs are important drivers of pass-through into domestic Belgian prices, and incomplete pass-though into Belgian export prices, with the imported input share being heterogeneous in firm size. I incorporate imported intermediates into the model in Appendix C as an extension. While imported intermediates do boost passthrough of competitors’ RERs, its quantitative size depends whether imported inputs are sourced from countries that are also competitors in the same sector. This is likely to be sensitive to factors like country

by the trade-weighted exchange rate (TWI) excluding the bilateral rate. In the rest of the paper I use an import-weighed measure at the sectoral level.

> 2It is important to control for US materials costs in the data. These costs can be highly correlated with exchange rates, leading to large estimates of stand-alone pass-through of competitors’ RERs to US producer prices, which the baseline model has difficulty rationalizing.