Chapter 2 Literature review
Goldberg & Knetter (1997) and Goldberg & Hellerstein (2008) review the micro-foundations of ERPT from the perspective of import prices. Exporters set prices in their domestic currency (the producer currency) and those prices depend on costs and the firms' mark-up (because firms are imperfectly competitive they are able to price above marginal cost). The exchange rate at time t enters the equation for the export price denominated in the local (importer's) currency. ERPT is defined as "the percentage change in local currency import prices resulting from a one percent change in the exchange rate between the exporting and importing countries" (Goldberg & Knetter 1997, p.1248).
Complete ERPT occurs when the variation in the local currency price of the good mirrors the change in the exchange rate. Incomplete pass-through occurs when a change in a bilateral exchange rate is not completely transmitted into the local currency price of a traded good. Symmetrically, incomplete pass-through implies that some part of the exchange rate movement is absorbed by the exporter, through variation in the received unit price, while complete pass-through implies that the exporter does not absorb any of the exchange rate variation. Whether this has a positive or negative effect on exporters' returns will depend on the direction of the exchange rate change, as well as any impact on the volume of exports.
There are several theoretical explanations for incomplete pass-through, at least in the short run. Some of these reasons - pricing-to-market, menu costs, and implicit or explicit contracts with offshore customers - have direct implications for the profitability of the exporting firm. Others imply that the pressure to adjust prices in response to exchange rate fluctuations may be muted for some firms, for example through explicit exchange rate hedging or compensatory changes in the cost of imported inputs. A final set of factors suggest that traditional ERPT measures based on aggregate data may be biased due to an inability to identify changes in the composition or quality of the exported goods over time. In this section we briefly review the empirical literature on ERPT and pricing-to-market, with a focus on firm- and product-level studies.
