Exchange-Rate Pass-Through

Exchange-rate pass-through is the extent to which a change in the exchange rate changes domestic prices. When the domestic currency depreciates, more units of domestic currency are required to buy the same foreign-currency-priced import, creating imported inflation. Pass-through may occur at import, producer and consumer-price stages, and is usually gradual and less than one-for-one.

Transmission through the economy

If E is the domestic-currency price of foreign currency and P* is the foreign-currency price of an import, its domestic-currency price is approximately E × P*, before adding taxes and domestic costs. Thus, depreciation raises the domestic cost of imports when the foreign price is unchanged.

• Imported final goods become more expensive directly, although contracts, hedging and firms' margins may delay the retail-price increase.
• Imported energy, raw materials, components and capital inputs raise firms' production and transport costs.
• Firms may absorb higher costs by reducing profit margins or pass them on through higher producer and consumer prices.
• Higher transport and distribution costs can spread the initial shock from imported items to domestically produced goods and services.
• If the initial price rise affects inflation expectations and wage-setting, second-round effects can make inflation broader and more persistent.
• Consumers and firms may substitute domestic products for costlier imports, but the extent of adjustment depends on domestic supply capacity and availability of substitutes.

Why pass-through varies

The same depreciation need not produce the same inflation outcome across countries, sectors or time periods.

• Pass-through is larger when imports have a high weight in consumption or domestic production.
• A rise in global commodity prices can amplify depreciation-induced inflation, while a fall can offset it.
• Exporters and importers may alter mark-ups rather than immediately changing domestic prices.
• Competitive markets and weak demand may limit firms' ability to pass higher costs to consumers.
• The currency in which trade is invoiced and the duration of existing contracts influence the timing of price adjustment.
• Taxes, subsidies and administered-price arrangements can alter the transmission from landed cost to retail price.
• A persistent depreciation generally produces greater pass-through than a small or temporary movement.
• Well-anchored inflation expectations and credible monetary policy can restrain second-round effects.

Measurement and economic significance

Pass-through is commonly expressed as the percentage change in a domestic price index resulting from a 1 per cent exchange-rate change over a stated period. It can be estimated separately for import prices, producer prices and consumer prices.

• Pass-through generally weakens along the pricing chain because consumer prices also contain domestic wages, rents, distribution costs and taxes.
• Higher consumer prices reduce the purchasing power of household incomes and may weaken consumption.
• Costlier imported inputs can compress firms' margins, discourage production or investment, and slow growth if firms cannot substitute domestic inputs.
• Monetary policy must distinguish a temporary relative-price shock from persistent, generalized inflation driven by expectations and second-round effects.
• The inflationary effect is not mechanically equal to the depreciation rate because global prices, margins, contracts, policy measures and domestic demand also change.

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