Reasons behind the effects of a weaker Euro

“The art and science of asking questions is the source of all knowledge.” Thomas Berger

In Getting low: the effects of a weaker Euro I discussed, through the lens of exchange rate pass-through, how the potential (and foreseeable) loosening of Eurozone monetary policy will likely affect Euro area economies. Considering the importance of this characteristic in determining the outlook of both growth and inflation, as well as the extent of easy monetary policy in the Euro area, it seems worthwhile to discuss why these countries show the pass-through that they do. In this post, I’ll outline the main theoretical aspects that determine the magnitude of PT. For those who are interested, Burstein and Gopinath (2013) carry out a more comprehensive (and better written!) review of the current academic literature around this topic.

Recall the chart and a couple of observations from my last post:

Observation 1: The import price PT is less than 1 for all countries. Put simply, a 10% depreciation in the euro translates to a less-than-10% rise in import prices. 

Observation 2: Export prices rise when the currency falls. This means that exporters raise the price of their goods (in Euros) as the euro depreciates.

Explanation 1: Invoicing currency decisions

An exporter can choose to price their international goods in either their own currency, or the currency of the foreign consumer. Choosing to price their goods in their own currency, defined as Producer Currency Pricing (PCP), means that a given depreciation of the currency will mechanically feed through into a lower price for the foreign consumer. As such, this pricing strategy gives rise to high PT and the expenditure-switching effect. 

If the producer prices their good in the currency of the foreign consumer, called Local Currency Pricing (LCP), then the currency depreciation has no effect on the effective price for the foreign buyer (as its already denominated in their own currency). Consequently, there is no PT, the foreign buyers don't buy more of the good and so there is no expenditure-switching effect.

This goes some way in explaining observation 1. Given the reserve-currency status of the Euro (it is one of the most important currencies in the world), it doesn’t seem inconceivable that some of these imported goods are priced in Euros. Indeed, that’s what we see in the data. According to Eurostat, 41% of imports to the euro area in 2012 were priced in euros in 2012, second only to the USD (which stood at 55%). As a euro depreciation won’t directly change the price of those imports priced in euros, 41% (as of 2012) of the imports to the euro area won’t change in effective price - explaining why the data do not show full import price PT.

Explanation 2: The currency of costs

In this day and age, an exporter will not build his whole product in one country. For example, VW in Germany will not source all its materials and parts within the Eurozone. Rather, it import parts from the US and China etc. and then combine these to build a VW Golf that is then exported. Consequently, a depreciation does not only affect a firm’s revenue (by affecting how much the car sells for abroad), but also its costs in the form of imported intermediate goods. If the euro depreciates, the cost of a car part from the US (contracted in USD - remember around 55% of euro area imports are priced in dollars) becomes more expensive, raising its production cost for the entire car. This means then, that the German exporter has to raise its price to ensure its profit margin stays constant.

This can be used to explain observation 2. As the euro depreciates, producers try to maintain their profit margins by raising their export prices to counteract the increase in imported intermediate-good costs.

Explanation 3: The production capabilities of firms

This explanation stems from the economic theory of returns to scale. Broadly, this states how a firm’s costs change as the quantity it produces increase. The normal assumption (and one that has a large standing in the empirical literature as well as lot of theoretical models) is decreasing returns to scale (DRS). This states that the more a firm produces, the more costly it is to produce one unit of output. Imagine VW produced 5 cars at a cost of €5,000 (€1,000 each). If VW had DRS, producing 10 cars would cost them €15,000 (€1,500 each). [Incidentally, if it cost them €10,000 to make 10 cars (€1,000 each), we would say VW had constant returns to scale.]

How does this fit into our PT story? Well, a depreciation means that euro area goods are somewhat cheaper for foreign consumers (not 1-to-1 cheaper, because we know PT isn’t full, but we know that there is some change in prices), so demand for these goods rise. To meet this increased demand, that firms have to increase their output. But if they exhibit DRS, then each unit (on average) now costs more than before. Similar to in Explanation 2, firms raise their export prices in response, as they try to maintain their profit margin. The result is that we end up with another explanation for observation 2, where exports prices (in euros) rise as the euro depreciates.

It is important to note that explanation 3 works better if we see large changes in the exchange rate. An increase in demand from 5 to 6 cars would not affect a firm’s costs as much as an increase from 5 to 20. Given I used monthly changes in last week's analysis, this may not include large enough changes in the euro to capture explanation 3 in its entirety. Even so, I think it's still an aspect worth appreciating to understand the drivers of pass-through more generally.

The bottom line

While there are many other aspects determining the magnitude of exchange rate pass-through (see Burstein and Gopinath (2013) for a more technical discussion), the three highlighted above seem the most relevant given we are looking at the relationship between aggregate price indices and the trade-weighted euro. Though the previous post states and discusses this relationship, this post goes some way into explaining why these relationships exist. Consequently and importantly, it allows us to have a framework by which to understand how and why these relationships might change going forward. It is, no doubt, a great example of how important asking the question ‘why?’ is to the attainment of knowledge.