2.4 Product composition and quality
Many studies have estimated the relationship between exchange rate fluctuations and prices using export unit value data at the product-country level. However, this level of aggregation may be problematic for the analysis of ERPT if exchange rate fluctuations are systematically related to product composition. Lavoie & Liu (2007) show that the income effects for foreign consumers associated with an appreciation of the currency will lead them to demand a higher quality version of export goods. This reduces the degree of observed ERPT into local currency unit values, as the fall in the producer currency will be offset by an increase in the average quality, and hence average producer price, of the goods.
Alternatively, if appreciation of the local currency makes a market more attractive for domestic exporters, the heterogeneous quality model of Baldwin & Harrigan (2011) suggests that this will encourage entry among lower quality producers, reducing the average unit value (and hence overestimating the degree of ERPT). Empirical research using aggregate data - even that using highly detailed product classifications - is therefore likely to misrepresent the extent of pass-through in continuing exporters.
We reduce composition concerns as much as practicable given the available data by indexing over firm, good and destination. The next section demonstrates that a substantial proportion of unit value variation is explained by firm, good, and destination controls.[5]
Notes
- [5] Theoretical work by Bernard et al. (2011) suggests that quality sorting mayoccur within as well as across firms. To the extent that New Zealand firms export varieties of differing quality within a product classification some bias may remain in our results.
