FRBSF Economic Letter
2006-23; September 15, 2006
The Exchange Rate-Consumer Price Puzzle
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Since February of 2002, the dollar has lost 27%
of its value relative to other major currencies. Over the same
period, consumer prices (excluding food and energy goods) have
increased by a much smaller amount—8.9%. To economists, and
particularly to central bankers and others who think about forecasting
inflation, this relative insensitivity of consumer prices to
exchange rates is a puzzle; indeed, it is one that has a long
history and that is a characteristic not only of the U.S. but
of other countries as
well.
Why is it a puzzle? Because international trade
theory argues that, if all goods and services were traded at
a negligible cost and if their prices reflected only their production
costs, then retail prices should be very responsive to exchange
rate changes.
Of course, one might expect that the solution
to the puzzle is in part related to the distances and costs involved
in shipping goods, as that would clearly imply that trading costs
are not negligible. But recent research suggests that other factors
are better at explaining not only why consumer prices are relatively
insensitive to exchange rate movements but also why they are
even less sensitive than import prices. One explanation rests
on the inclusion of non-traded good and service costs as part
of the consumer price index (CPI). While import prices may respond
to exchange rate changes, consumer prices, which include many
non-traded cost components, may not. A second explanation arises
from the profit margins that foreign exporters and local distributors
have as a result of imperfect competition. Exporters and distributors
may choose to adjust their profit margins rather than change
price levels in response to exchange rate changes, for example,
to maintain market share.
This Economic
Letter first reviews the empirical evidence on exchange
rates, import prices, and consumer prices. It then discusses
recent studies that evaluate alternative theories to explain
the puzzle.
Empirical evidence
In principle, retail prices should primarily
reflect the dollar production cost of a good. If all U.S. and
foreign goods and services were traded at a negligible cost and
their markets were perfectly competitive (so that their prices
reflected only the costs of producing them) then their prices
would be very sensitive to the exchange rate. For example, suppose
you were importing a car from South Korea. In a simple economic
model, the U.S. price of the car would simply be the price of
the car in Korean won multiplied by the dollar-won exchange rate.
If the dollar depreciates against the won, then the cost of the
same car in dollars would increase in the same proportion.
However, in practice, final goods prices are
not very sensitive to the exchange rate. Indeed, as Campa and
Goldberg (2006) find, consumer prices are much less sensitive
to exchange rate changes than import prices. They use quarterly
import price, CPI, and exchange rate data from 13 OECD countries
spanning the period 1975 to 2003. Campa and Goldberg find that,
in the long run (measured over four quarters), a 10% depreciation
of the local currency leads to an average 6% increase in import
prices and to only a 2% increase in consumer prices. For the
United States in particular, the authors find that the same depreciation
leads to a 4% increase in import prices and only a 0.1% increase
in consumer prices.
Possible solution to the puzzle: distance?
It is natural to guess that consumer prices are
insensitive to the exchange rate because of the substantial costs
involved in shipping goods over the long distances between countries;
for example, a large fraction of the U.S. cost of a car made
in South Korea will reflect the shipping costs. Suppose the South
Korean won appreciates vis-à-vis the dollar. This raises the
dollar cost of the car in Korea. But if the shipping costs are
substantial and are not affected by the appreciation of the won,
then the cost of the car at the U.S. dock also may not be affected
much.
Engel and Rogers (1996), however, present evidence
that suggests that geographical distance is not the main determinant
for the lack of consumer price sensitivity to exchange rate movements.
Engel and Rogers study the behavior of consumer prices between
cities in Canada and the United States, which share a very large
and relatively open border. The study finds that consumer prices
in nearby cities within each country, say, New York and Philadelphia
or Ottawa and Quebec, tend to move more closely together than
prices of cities further apart, say, New York and Los Angeles
or Ottawa and Victoria. This reflects the fact that cities in
close proximity face lower transport costs. However, Engel and
Rogers also find that prices between distant cities in the same
country, say, New York and Los Angeles, move more closely together
than prices between nearby cities in different countries, such
as New York and Toronto. In fact, they estimate that the national
border between the United States and Canada adds the equivalent
of an extra 1,700-20,000 miles of distance in explaining the
differences between prices in U.S. cities and Canadian cities.
Thus, it appears that national borders play a
more important role than physical distance in explaining the
behavior of consumer prices. Moreover, given the greater sensitivity
of import prices to exchange rate fluctuations relative to consumer
prices (Campa and Goldberg 2006, Valderrama 2004), the low sensitivity
of final goods prices seems to be related to what happens to
imported goods after they arrive at the port and before they
reach consumers.
Possible solution to the puzzle: non-traded goods
and services?
One reason why measures of consumer prices are
so insensitive to exchange rate movements is that some goods
and services may not be traded internationally at all. Consider,
for example, services, such as haircuts and other kinds of personal
grooming, as well as office and retail rental space, and many
managerial and other specialized services. The prices of these
goods may be determined entirely by domestic conditions. Many
of these non-traded good and service prices are directly included
in the CPI.
The retail price of many traded consumer goods
also includes many non-tradable goods and services as cost components.
These costs include transportation, marketing, wholesaling, and
retailing, which may be intensive in local labor and services;
I will call these distribution costs. Feenstra (1998) provides
an illuminating illustration of how sizable such non-tradable
distribution costs can be: In 1996 a Barbie doll shipped from
China to the United States cost about $2, where it sold for about
$10. The manufacturer, Mattel, earned about $1 of profit on this
doll. The remaining $7 represented payments for transportation
in the United States and other distribution costs.
Burstein, Neves, and Rebelo (2003) find that
distribution costs are a large component—about 40%—of overall
U.S. consumer prices. Campa and Goldberg (2006) find that distribution
margins average about 20% of the price in 29 industries and can
be as high as 70% to 90%. Transportation costs amount to only
about 5% of these costs, except for mining and resource-intensive
industries. As a share of output for each country, distribution
margins average 15% to 25%, and for the U.S. specifically, they
are 24%.
Possible solution to the puzzle: changing profit
margins?
An alternative explanation for the insensitivity
of consumer prices to the exchange rate is that retail prices
do not fully reflect changes in costs. In practice, many goods
and services are produced in imperfectly competitive markets.
In terms of prices for these goods, firms are able to make a
profit margin over costs. Firms may choose not to pass on the
full change in costs brought about by changing exchange rates
and instead choose to change their profit margins, thus reducing
the sensitivity of consumer prices to the exchange rate. Since
the evidence suggests that consumer prices are more insensitive
to exchange rate movements than import prices, this explanation
would imply that there may be imperfectly competitive domestic
firms that distribute imported goods and are willing to adjust
their margins in response to import price changes.
Bacchetta
and van Wincoop (2002) build a model that ignores the non-tradable
distribution costs and instead focuses on differences in competition
between foreign and domestic firms. In their model, foreign exporters
send goods to domestic firms, which in turn sell them to consumers,
and both foreign exporters and domestic firms are imperfectly
competitive. Each firm makes pricing decisions to maximize profits.
Foreign exporters face competition for their product from all
other goods that consumers demand, including some non-tradables.
Domestic firms, however, compete only with other domestic firms.
Since foreign exporters face more competition, they choose to
price their goods in terms of domestic costs. Thus, when the
domestic exchange rate rises and the cost of imported goods in
terms of domestic currency rises, foreign exporters choose to
pass the cost increase to import prices. However, since domestic
distribution firms face competition only from other domestic
distribution firms, they choose to keep prices stable in terms
of the domestic currency. In this model, import prices fully
reflect changes in the exchange rate, while consumer prices do
not. Indeed, Campa and Goldberg (2006) find that the relative
lack of competition in the distribution sector is an important
determinant of the relative insensitivity of consumer prices
to the exchange rate.
Conclusions
The insensitivity of consumer prices to exchange
rate fluctuations represents a price puzzle to economists. While
distance and transportation costs might seem natural solutions
to the puzzle, research suggests that non-tradable costs of distributing
goods domestically and adjusting profit margins of imperfectly
competitive firms are two more plausible explanations.
Diego Valderrama
Economist
References
[URLs accessed
September 2006.]
Bacchetta, Philippe, and Eric van Wincoop. 2002. "Why
Do Consumer Prices React Less Than Import Prices to Exchange
Rates?" NBER Working Paper 9352.
Burstein, Ariel, Joao Neves, and Sergio Rebelo.
2003. "Distribution Costs and Real Exchange Rate Dynamics
during Exchange-Rate-Based Stabilizations." Journal
of Monetary Economics 50 (September) pp. 1189-1214.
Campa, José Manuel, and Linda S. Goldberg. 2006. "Distribution
Margins, Imported Inputs, and the Sensitivity of the CPI to Exchange
Rates" NBER Working Paper 12121.
Engel, Charles, and John H. Rogers. 1996. "How
Wide Is the Border?" American
Economic Review 86 (December) pp. 1112-1125.
Feenstra, Robert. 1998. "Integration of
Trade and Disintegration of Production in the Global Economy." Journal of Economic Perspectives 12 (Autumn) pp. 31-50.
Valderrama, Diego. 2004. "Does
a Fall in the Dollar Mean Higher U.S. Consumer Prices?" FRBSF
Economic Letter 2004-21 (August 13).
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