The Exchange Rate Disconnect
Why do large movements in exchange rates have small effects on international goods prices? This empirical regularity is a central puzzle in international macroeconomics. In a new study, we show that the key to understanding this exchange rate disconnect is to take into account that the largest exporters are also the largest importers. This is important because when exporters import their intermediate inputs, they face offsetting exchange rate effects on their marginal costs. For example, a depreciation of the euro relative to the U.S. dollar makes exports in U.S. dollars cheaper—but it also makes imports in euros more expensive. Using Belgian firm-level data, we show that exporters that import a large share of their inputs pass on a much smaller share of the exchange rate shock to export prices. Interestingly, import-intensive firms typically have high export market shares and hence set high markups and actively move them in response to changes in marginal cost, thus providing a second channel that limits the effect of exchange rate shocks on export prices. Our results show that a small exporter with no imported inputs has a nearly complete pass-through of more than 90 percent, while a firm at the 95th percentile of both import intensity and market share distributions has a pass-through of 56 percent, with the two mechanisms playing roughly equal roles. These findings have important implications for aggregate macroeconomic variables.
The National Bank of Belgium, our primary data source, provides highly disaggregated export and import data at the firm level. The data set includes information on approximately 10,000 distinct product categories by destination and source country. We use unit values to proxy for a firm’s export price, defined as the ratio of export value to export quantity. One potential problem with this measure is that, even within this fine level of disaggregation, there may still be compositional shifts within the product categories. However, studies that draw on price data have not been able to match import and export prices at the firm level.
Most importantly, using the trade data enables us to construct an exporter’s import intensity, which is an essential ingredient for this study. The firm’s import intensity is defined as the ratio of imported intermediate inputs to total variable costs as described in our theoretical framework. It is important to know the country source of a firm’s imports so that we can net out the imports originating from within the euro zone since these are in the same currency as Belgium domestic costs. In order to get a measure of the firm’s total variable costs, defined as total material costs plus the wage bill, we merge the trade data with firm-level characteristics. We can also directly measure a firm’s marginal cost that is potentially sensitive to exchange rate movements as an import-weighted change in the firm’s import prices, which we proxy for using unit values (the ratio of import value to import quantities). The final key ingredient in the study is a measure of the firm’s market share in each destination, which we construct for each firm-product-destination-time. This measure is an indicator of the firm’s mark-up variability.
Stylized Facts about Exporters and Imports
A new interesting stylized fact to emerge from our analysis is that there are large systematic differences across exporters. Previous studies have emphasized the differences between exporters and non-exporters, highlighting that exporters are bigger, more productive, and pay a wage premium—features that are also present in our data. However, even within the select group of firms that are exporters, there are very large differences between high import-intensive exporters and low import-intensive exporters. Splitting the sample based on the median import intensity, we show in the table below that import-intensive exporters are larger in terms of employment and material costs, pay higher wages, are more productive, have higher market shares, export higher values, and export to more destinations; they also import more products and from more countries. These patterns turn out to be important in explaining the heterogeneity of exchange rate pass-through into export prices across different firms. Furthermore, because high import intensity firms are also firms with high export shares, these results help explain low aggregate pass-through.
The Main Findings
Firm market share and import intensity are the two key determinants of pass-through at the firm-level, consistent with the theory, and explain a wide range of variation in exchange rate pass-through. Specifically, small exporters have a nearly complete pass-through, that is, they pass on almost 100 percent of the exchange rate change into export prices. In contrast, the largest exporters, which are simultaneously the largest importers, have an exchange rate pass-through of only slightly above 50 percent. Roughly half of this incomplete pass-through is due to the offsetting effects of an exchange rate change on marginal cost (which we proxy using the firm’s import intensity), with the other half due to the variation in the markups (which we proxy using the firm’s market share). Firms with large market shares adjust their markups more than small firms in response to cost shocks. Furthermore, since import intensity is heavily skewed toward the largest exporters, this helps explain the observed low aggregate pass-through.
Indeed, a large share of exports comes from large firms that source their inputs globally and are thus only partially linked to the domestic market conditions in their home country. As a result, these firms are effectively hedged against the exchange rate fluctuations and do not need to fully adjust their prices. Furthermore, these are the strong-market-power firms, setting high markups, which they actively move in response to shocks. Our results provide evidence that high market share firms have more variable markups. To sum up, the prices of the largest firms, accounting for the disproportionate share of trade, are insulated from exchange rate movements both through the hedging effect of imported inputs and active offsetting markup adjustment in response to cost shocks.
We show that taking into account that large exporters are also large importers can help explain differences in exchange rate pass-through across firms as well as low aggregate pass-through. Further, we decompose the incomplete pass-through into the marginal cost channel and mark-up channel, finding a roughly equal contribution of each channel. These results have important implications for international macroeconomics as price sensitivity to exchange rates is central for the expenditure-switching mechanism at the core of international adjustment and rebalancing. Understanding why there is incomplete pass-through is important from a welfare perspective as the implications differ if incomplete pass-through is due to different distributions of markups across firms or to complex global sourcing patterns, which directly affect marginal costs.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Mary Amiti is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.
Oleg Itskhoki is a professor of economics at Princeton University.
Jozef Konings is professor of economics at University of Leuven.