2.2 Nominal price stickiness - menu costs and long term contracts
Menu costs of price adjustment and long-term contracts are another common explanation for incomplete ERPT. Menu costs include the administrative, technical and informational costs of deciding on and implementing a price change (see reviews by Ball & Mankiw 1994 and Andersen 1994). These costs prevent firms from immediately reacting to changes in demand or costs, particularly where there is some uncertainty about the magnitude or duration of the change. Explicit contracts, in turn, create rigidity in prices for a specified period of time, delaying firm-level price adjustments in response to exchange rate fluctuations.
If nominal prices are sticky in the currency of invoice then ERPT will be mechanically determined by the choice of currency in the short run. From the perspective of the foreign buyer, contract prices denominated in the producer currency (NZD) will exhibit complete pass-through, those denominated in local (importer) currency will show zero pass-through, and observed pass-through for goods invoiced in vehicle currencies will directly reflect the relative movement of the local and vehicle currencies.
Gopinath & Rigobon (2008) use product-level survey data from US importers to show that rather than pricing reflecting a desire to smooth prices in the buyer's currency, most price stickiness is observed in the currency of invoice. Hence, the ability to identify invoice currency is central to identifying the effect of exchange rates on prices, at least in the short-term (Goldberg & Knetter 1997).
The literature on endogenous currency choice suggests a range of factors which may influence the decision to invoice in local, producer or vehicle currencies. For example, currency choices may be driven by a desire to limit transactions costs (eg, Krugman 1984), to minimise volatility (eg, Donnenfeld & Haug 2003), or to maintain stable prices relative to competitors, especially when demand is elastic (eg, Goldberg & Tille 2008).
While invoice currency has traditionally been treated as a choice for the exporting firm, Friberg & Wilander (2008) conclude that, for Swedish exporters, both the price and the currency of invoice are more commonly negotiated with the importer rather than set unilaterally. This process of negotiation implies that relative bargaining power will have an impact on both pricing and currency choice. For example, Goldberg & Tille (2009) find that while large shipments are more likely to be invoiced in local currency (which they argue reflects the larger opportunity cost to the exporter if the sale falls through), countries that provide a dominant share of imports in a particular industry are more likely to invoice in the producer currency. Similarly, Friberg & Wilander (2008) find that large orders, and export sales to large countries, are more likely to be invoiced in the importer's currency.
The choice of invoice currency is an important theme of this paper. We observe clear systematic relationships between invoice currency and firm characteristics, with large exporters and those exporting to multiple countries more likely to invoice in vehicle currencies. Taking currency choice as given, we then examine the impact of exchange rate fluctuations on export unit values within each invoice currency type, ie, producer (NZD), local, and vehicle. Together, this analysis allows us to demonstrate how invoice currency choice is related to ERPT for various firm types, without the need to explicitly model currency choice.
