DIFFERENCES IN EXCHANGE RATE PASS-THROUGH IN THE EURO AREA*

Transcription

1 DIFFERENCES IN EXCHANGE RATE PASS-THROUGH IN THE EURO AREA* José Manuel Campa (IESE Business School and Banco de España) Jose M. González Mínguez (Banco de España) July, 2002 keywords: exchange rae, pass-hrough, euro, moneary union. *We would like o hank Linda Goldberg, Agusín Maravall, Javier Vallés, and seminar paricipans a he Bank of Spain and FEDEA for helpful commens. We would also like o hank Nadim Ahmad a he OECD and Denis Leyhienne a Eurosa for help in gahering he daa and Juan C. Caballero, María Oleaga and César Roa for excellen research assisance. 1

2 Absrac This paper focuses on he pass-hrough of exchange rae changes ino he prices of impors made by euro area counries originaing ouside he area. Using daa on impor uni values for hireen differen produc caegories for each counry, we esimae indusry-specific raes of pass-hrough across and wihin counries for all euro members. In he shor-run, pass-hrough raes differ across indusries and counries and are less han one. In he long-run neiher full pass-hrough nor equaliy of pass-hrough raes across indusries and counries can be rejeced. Differences exis across euro area counries in he degree ha a common exchange rae movemen ges ransmied ino consumer prices and coss of producion indices. Mos of hese differences in ransmission raes are due o he disinc degree of openness of each counry o non-euro area impors raher han o he heerogeneiy in he srucure of impors. Resumen Ese rabajo se cenra en la ransmisión (pass-hrough) de los movimienos del ipo de cambio a los precios de las imporaciones realizadas por los países del área del euro y procedenes de fuera de la misma. Haciendo uso de daos de índices de valor uniario para rece caegorías disinas de producos para cada país, se esiman asas de pass-hrough específicas para cada indusria para los disinos países miembros de la Unión Económica y Monearia (UEM). A coro plazo, las asas de pass-hrough difieren enre indusrias y países y son menores que uno. A largo plazo no se puede rechazar ni que el pass-hrough sea compleo ni que sea el mismo para odas las indusrias y países. Sin embargo, exisen diferencias enre los países del área del euro en cuano al grado de ransmisión de una variación dada del ipo de cambio a los índices de precios de consumo y a los coses de producción. La mayor pare de esas diferencias en las asas de ransmisión se deben al disino grado de aperura de cada país a las imporaciones desde fuera del área, y no ano a la heerogeneidad en la esrucura de las imporaciones de cada país. 2

3 I. INTRODUCTION Exchange rae pass-hrough is he rae a which changes in exchange raes ge refleced in impor prices expressed in he currency of he imporing counry. This rae of ransmission has been he focus of ineres in he inernaional lieraure for a long ime. Iniially his focus cenered in he debae over he law of one price and convergence across counries. Beginning in he lae 1980s, exchange rae passhrough sudies emphasized indusrial organizaion phenomena and he role ha inernaionally segmened markes and price discriminaion played in deermining impor prices. More recenly pass-hrough issues have played a cenral role in heaed debaes over appropriae moneary policies and exchange rae regime opimaliy. 1 These debaes hinge on he issue of he prevalence of producer-currency pricing (PCP) versus local-currency pricing (LCP) of impors, and on wheher exchange rae pass-hrough raes are endogenous o a counry s inflaion performance. High impor price pass-hrough means ha nominal exchange rae flucuaions may lead o higher expendiure swiching effecs of domesic moneary policy. If pass-hrough raes are endogenous o a counry s relaive moneary sabiliy, he exen of his moneary policy effeciveness may be fragile and regime-specific. 2 A major concern wih he creaion of he euro area and he esablishmen of he single moneary policy has been he exen o which he single moneary policy can have differenial effecs in he economies of he differen member counries. Several reasons have been suggesed in he lieraure for hese differenial effecs. These argumens include differences in financial sysems (or, more generally, in he naional moneary policy ransmission mechanisms), cyclical divergences among counries, differing insiuional arrangemens in he labour markes, he degree of economic developmen and exposure o inernaional rade. One major source of concern is he differenial effecs ha can accrue o shocks arising from ouside he euro area. Such effecs can be due o differences in rade exposure or in he srucure of rade by producs or by parner counries. For insance, a euro depreciaion can lead o differences in he degree of consumer price increases due o changes in he euro price of impors. These differences ge refleced direcly in he indicaor used o measure he performance of euro-wide inflaion by he European Cenral Bank (ECB), he Harmonized Index of Consumer Prices (HICP). This index is 1 The implicaions of pass -hrough performance for opimal moneary policy are also explored in Corsei and Peseni (2001), Obsfeld (2000), Devereux (2000), and Devereux and Engel (2000), among ohers. 2 See Taylor (2001). The role of he invoicing decisions of producers in influencing pass-hrough raes is explored in recen work by Devereux and Engel (2001) and Bacchea and van Wincoop (2001). 3

4 a broad measure of inflaion, in which baske impored goods are included, so ha is overall behaviour is affeced by changes in commodiy and oher impors prices. The evoluion of hese prices is exogenous o he ECB and can affec euro member counries in differen ways. In paricular, he recen exogenous oil price shock, ogeher wih he rise of he dollar, impaced differenly on he euro area member economies (Galí, 2001). This was relaed o facors such as he respecive degrees of inensiy of use of oil in heir economies, he reliance in impored oil and he srucure of indusrial compeiion wihin each counry. Therefore, differences in rade srucures of he member counries (in a very broad sense) migh lead o differenial effecs of a single moneary policy. We focus in his paper on he pass-hrough of exchange rae changes ino prices of exra-emu impors of he welve counries which are he curren members of he euro area (alhough Belgium and Luxembourg are reaed as a single counry). We use ime series daa on impor uni values for hireen differen produc caegories for each counry. We focus on impors from non-euro area member counries since his is he par of he oal rade of he counries which has coninued o be exposed o exchange rae flucuaions afer he creaion of he euro zone in Our daabase has he advanage of focusing explicily on he composiion of impors ino he desinaion counry by produc and by counry of origin, enabling us o accoun for differen raes of pass-hrough for he differen produc caegories. This variaion is imporan when invesigaing he ransmission of exchange rae changes o aggregae price indicaors, such as he HICP or a measure of he inermediae coss of he economy. Furher, he possibiliy o calculae produc and counry-specific raes of exchange rae pass-hrough ino impor prices enables o underake a meaningful analysis of differences in pass-hrough raes across and wihin counries as arising from he produc composiion of impors exposed o exchange rae flucuaions. One goal of his paper is o invesigae how large could be he differenial impac of changes in he euro exchange rae on he inflaion rae of he differen member counries. This differenial effec could arise due o hree main channels: differen degrees of openness of he member counries economies o non-euro area impors; an heerogeneous produc composiion of impors coming from ouside he euro area for given indusry-specific raes of pass-hrough; or, differen produc and counry-specific raes of pass-hrough o impor prices for any given composiion. The paper shows ha he differences in inflaion raes arising from a common euro 4

5 depreciaion can be subsanial and ha mos of hese differences are due o he degrees of openness of he member saes o producs coming from non-euro area counries. The res of he paper is organized as follows. In he nex secion, we provide a review of he lieraure linking exchange raes and impor prices. Secion 3 describes he daa used in he empirical analysis of his relaionship. Secion 4 presens he main resuls on he esimaed pass-hrough elasiciies o impor prices. Secion 5 gives a breakdown of he differences in pass-hrough raes o consumer prices and o he oal cos of inpus accouned for by he openness of he counry, he produc composiion of impors and he exisence of produc- and counry-specific passhrough raes. Secion 6 brings ogeher some conclusions and poins owards some areas for furher work. II. EXCHANGE RATES AND PRICES Analyses of he linkages beween exchange raes and prices have followed numerous pahs. Early sudies were moivaed by he macroeconomic debae on exchange raes and monearism. More recen sudies focus on issues relaed o he degree of marke inegraion associaed wih he fulfilmen of he law of one price and wih he role of marke microsrucure in he abiliy and desire of producers o price discriminae 3. Empirical ess of associaed hypoheses revolve around he familiar equaion: * EP P = (1) where P is he domesic price index, E is he nominal exchange rae (defined as he number of domesic currency unis per uni of foreign currency), and * P represens foreign prices. (Relaive) purchasing power pariy ess use price indices across counries o es wheher his relaionship holds. Law of One Price hypoheses es he same equaion for individual goods prices raded across counries. As nicely discussed in Goldberg and Kneer (1997), coss of ransporaion or resale (such as rade barriers) migh preclude price equalizaion bu give rise o a sable wedge beween price indices expressed in erms of equaion (1). 3 Goldberg and Kneer (1997) provide a very comprehensive overview of his lieraure. 5

6 Exchange rae pass-hrough sudies consider he exen o which exchange rae movemens are passed-hrough ino raded goods prices, versus absorbed in producer profi margins or markups. Ofen hese sudies look a indices of indusrial concenraion or marke power o explain pass-hrough differences or pricing-omarke. The exbook definiion of exchange rae pass-hrough (ERPT) is he percenage change in local currency impor prices resuling from a one percen change in he exchange rae beween he exporing and he imporing counry. This definiion is ofen empirically implemened as an saisical relaionship of he elasiciy of impor prices o exchange raes. Evidence on ess of his relaionship are basically he γ esimaes based on a simple equaion p = γe + ε (2) where all lower-cased variables are in logs and ε is an error erm. 4 This reduced form equaion (wheher in log levels or growh raes) is problemaic for hypohesis esing because i only represens a non-srucural saisical relaionship and lacks an economic inerpreaion. Micro-foundaions of pricing behavior are required for generaing more economically meaningful specificaions ha are appropriae for hypohesis esing. If he dependen variable is he home currency price of impors of produc j expressed in domesic currency, P mj,, he pricing equaion of an exporer of produc j - and is elasiciy of response o an exchange rae movemen - depends on he srucure of demand and coss confroning he exporer. If he impor price P is he dependen variable, he pricing rule of he foreign exporer x ha drives he deerminaion of he impor price is: j ( W,Y, E ) m, j m,j m, j x,j x,j P x,j = EP = EMKUP C P (3) P P where MKUP, C > 0, C < 0, C > 0. x, j x, j xj, xj, xj, x, j w E y C 4 The γ s are background informaion for he moneary policy debae discussed in Taylor (2000) and esimaed values are provided in sudies such as McCarhy (2000). While Taylor argues ha exchange rae pass-hrough elasiciies appear o have declined over ime for counries ha have reduced heir inflaion levels and inflaion variabiliy, here have no been sysemaic analyses verifying his asserion. 6

7 In equaion 3 x, j MKUP represens he markup rae of prices over coss for he exporer. Markup raes are indusry-specific and depend on he demand curve facing exporers x in produc j. This demand depends, in urn, on P mj, P, he prices, of impors relaive o prices of local compeiors. C x j is he marginal cos funcion of he exporer in is own currency. This exporer marginal cos funcion is increasing in expor marke wages, W x, j, and in produc j demand condiions, j Y, and decreasing in he exchange rae measured as he number of unis of he currency of he imporer per uni of currency of he exporer 5. The exchange rae is an argumen in he exporer s cos funcion o he exen ha he exporer relies on impored inpus or has oher coss ha move wih he relaive value of he desinaion marke currency. Equaion 3 shows ha empirical specificaions seeking o isolae pass-hrough elasiciies should inroduce conrols for he exogenous cos shifers enering ino foreign exporer pricing decisions. Wihou such conrols he measured relaionship is a saisical correlaion wihou specific economic inerpreaion in erms of exchange rae pass-hrough. III. DATA DESCRIPTION We focus in his paper on he pass-hrough of exchange rae changes ino impor prices of impors semming from ouside he euro zone ino he welve counries currenly belonging o he area 6. We use ime series daa on impor uni values for hireen differen produc caegories for each desinaion counry. We look a impors from ouside he euro area since his is he par of he oal rade of he counries ha has coninued o be exposed o exchange rae flucuaions afer is creaion in The incepion of he euro has reduced significanly he degree of exposure o exchange rae flucuaions of he member counries' inernaional rade, as well as alering he respecive shares of he differen producs subjec o hose flucuaions. Figure 1 shows, for each counry of he area, oal impors and impors coming from ouside EMU in 2000 as a share of GDP. As i can be seen, here are very large divergences among member counries as far as he raio of non-euro area impors o GDP is concerned. Ireland is he counry wih he highes share of impors semming from ouside he area o GDP, reaching nearly 40% in A he oher 5 More precisely, one should include as he appropriae demand variable an index of income levels across he producer s home marke and he desinaion marke for is expors. Since we do no have informaion on he composiion of demand facing exporers in differen counries, our proxy here is he GDP of he imporing counry. 6 In fac, due o daa availabiliy reasons, Belgium and Luxembourg are reaed as a single counry 7

8 end, for Ialy ha figure is only abou 11%. The disribuion of non-euro area impors also varies widely across differen produc caegories. Elecric and elecronic machinery, Basic manufacures and Mineral fuels accoun for he larges porion of non-euro area impors across all counries in he euro area. However, he shares of he various indusries in overall non-euro area impors shows a large degree of heerogeneiy wih, for insance very large shares for he caegory Mineral fuels in Porugal, Greece and Spain, bu relaively low shares in he caegory Elecric and elecronic machinery for hese counries (Figure 2). The daabase used in his paper includes monhly ime series of uni values of impors from non-euro area counries for hireen produc caegories. Eigh of hese caegories are defined a he one-digi SITC level of aggregaion and he oher five are he resul of disaggregaing he remaining wo one-digi caegories, namely Manufacured producs and Transpor equipmen, ino respecively hree and wo subcaegories 7. This daabase has he advanage of focusing explicily on he produc composiion of impors ino he counry and can hus accoun for differen raes of pass-hrough among differen produc caegories for any given counry. Accouning for hese divergences is imporan for any meaningful analysis of differences in passhrough raes across and wihin counries as divergences arising from he produc composiion of impors exposed o exchange rae flucuaions can accoun for a significan amoun of he aggregae differences of impor price pass-hrough across counries. Working wih such a large sample of produc caegories also comes a a cos. The impor price daa has several limiaions for an analysis of pass-hrough behavior. I is an index based on uni values raher han prices, which poses some problems concerning he comparabiliy of goods over ime. These uni value measures do no properly accoun eiher for changes in he definiion of produc caegories over ime due o changes in qualiy or for changes in relaive demand of similar goods or, finally, for changes in he composiion of hese impors by counry of origin. I is sill an aggregae price index, comprising all impored goods in he counry wihin ha produc caegory. The definiion of a produc is deermined by ad hoc inernaional indusry classificaions raher han by some underlying economic argumen. As a resul, differen produc caegories refer o very differen shares of a 7 See he daa appendix for deails regarding he daa. 8

9 counry s rade 8. Given he micro evidence suggesing ha large differences in passhrough migh arise from differences in he produc composiion of rade (Kneer (1993), Giovannini (1988), Freenberg (1998)), one has o be careful in comparing and inerpreing esimaes of pass-hrough elasiciies across counries wih very differen rade paerns. In order o mainain some comparabiliy of he indusry esimaions across counries, we decided o use he same indusry classificaion for all he counries in he sample. 9 The oher wo relevan pieces of daa are he nominal exchange raes and he marginal cos, or foreign price, proxy. An appropriae definiion of hese variables depends on an explici deerminaion of wha is he relevan inernaional marke for he produc. When world markes for he produc are inegraed, here exiss only a single inernaional marke for he produc, regardless of produc origin, desinaion marke or currency of denominaion. In his case, any measure of he world price should be he same when expressed in a common currency. Appropriae measures of he foreign price and he exchange rae would be a proxy of he world price in a common currency and he bilaeral exchange rae beween he currency in which he foreign price is denominaed and he home currency. In our case, he world price will be expressed in U.S. dollars. 10 Therefore, under his assumpion of he funcioning of inernaional markes we will use, for a given produc, he U.S. dollar price of he impors coming from ouside he area as our proxy for he foreign price and he bilaeral exchange rae beween he domesic currency and he U.S. dollar as our exchange rae measure. We will call his specificaion he inegraed marke. An alernaive view of he inernaional produc markes regards hese markes as highly segmened wih a significan degree of price discriminaion for he produc depending on he counries of origin and desinaion of impors. Under his view of he world, an appropriae measure for he bilaeral exchange rae and he foreign price index should be made coningen, for a given desinaion counry, on he counries in which hese impors originae. Under his assumpion, we use as our proxy for he exchange rae for each indusry he geomeric weighed averages of he bilaeral exchange raes of counry j agains is five major non-euro zone providers of impors of produc i. The weighs are given by each exporing counry's share wihin 8 For insance, produc caegories Beverages and obacco and Oher goods accoun for only 0.9% of rade while Vehicles and ranspor equipmen accouns on average for 2.7% of each counry s rade. 9 We chose o do his despie he fac ha he relaive imporance of each of hese produc groups varies significanly across he differen member counries of he euro area. 10 In fac any currency used as a numeraire would work. One could also use as a proxy for he world price an inernaional price of he produc and no necessarily he impor price ino he Euro area. 9

10 oal impors of ha good for he year For he foreign price, a geomeric weighed average of he foreign price indices is also used, where he weighs are he same as for he bilaeral exchange rae. Ideally, a disaggregaion of producer prices according o he ypes of produc would have been used. However, hese produc specific series are no available for many exporing counries even a an aggregae level, which led us o resor o aggregae consumer prices insead. We will call his specificaion he segmened marke. Given hese wo alernaive views abou inernaional markes, we will laer perform a se of specificaion ess o deermine which one of hem appears o bes describe he daa from an empirical poin of view. In order o esimae he exchange rae pass-hrough, we begin wih he following equaion i,j i, j 4 4 i,j i,j i,j i, j i,j al lner l + bl lnfp l v (4) l= 0 l= 0 ln MP = c + + where he superscrips indexed by i and j refer, respecively, o an indusry and o an imporing counry. We denoe as MP he impor uni value index j denominaed in local currency of indusry j in counry i. ER i, is he nominal effecive exchange rae for indusry j of counry i expressed in erms of unis of domesic currency per uni of foreign currency. Finally, i, j i, j FP sands for he price index of impors of indusry j ino counry i in he counries of origin of hese impors and expressed in foreign currency. Equaion (4) is a generalized direc ransformaion of equaion (1) where we have allowed for he possibiliy of parial adjusmen of he rule seing impor prices wih a flexible form ha includes four lags of he exchange rae and he foreign impor price. In principle, he adjusmen pah of impor prices could very well vary by indusry according o he characerisics of he produc, indusry srucure and oher facors such as disance beween rading parners or delivery lags. There could also be an imporan counry-specific effec driven by macroeconomic facors of he counry such as expeced inflaion raes or economic sabiliy. We are no ineresed in his paper in explaining differences in he speed of price adjusmen across indusries bu raher in capuring a measure of pass-hrough behaviour ha is sufficienly robus o esimaion echnique by using a flexible funcional form for is 10

11 esimaion. Therefore, we will no ry o idenify he opimal lagged adjusmen process for each indusry/counry combinaion in he sample. We have aken for esimaion he firs differences of he variables in equaion (1) o conrol for he possibiliy of nonsaionariy and he exisence of uni roos in he ime series variables conained in hese specificaions. We seleced his model specificaion over an error correcion model afer esing for he presence of uni roos in he original series (impor uni values, exchange raes and he proxy for he foreign price) and for he exisence of coinegraion among he variables in equaion (4). Firs, he exisence of uni roos was esed by means of he Augmened Dickey Fuller es (wih one lag and a rend). We found ha we could no rejec he null hypoheses of a uni roo in abou he half of all series. Aferwards, we searched for a long-run relaionship beween impor prices, exchange raes and foreign prices. For ha purpose, we performed Johansen ess o check for he number of coinegraing vecors and found ha for he vas majoriy of indusries he hypohesis of no coinegraion could no be rejeced 11. Given his evidence agains he presence of a coinegraing relaionship we chose o perform he analysis in a single equaion framework. coefficiens Shor-run exchange rae pass-hrough esimaes are given by he esimaed i j a, 0 while long run coefficiens are given by = a l 0 4 i, j l. There are wo benchmarks of pass-hrough esimaes ha we will focus on. A zero pass-hrough consisen wih he idea ha exporers fix impor prices in he imporer s local currency (LCP), and one which is consisen wih producers pricing expors in heir own currency (PCP). IV. DISCUSSION OF RESULTS We sar by performing some model specificaion ess o ry o deermine which specificaion of marke srucure is more appropriae o our daa. Two compeing specificaions were conrased. The firs one is a specificaion allowing for an inegraed world marke for radable producs priced in U.S. dollars, while he second advocaes for a world of segmened markes in which he counry of origin of he impors was imporan in deermining he marginal cos (i.e. he opporuniy cos) of impors ino EMU. 11 We allowed for wo lags and for an inercep in he coinegraing equaion. The exisence of a coinegraing relaionship could no be rejeced in 20 ou of 140 cases. 11

12 We performed he J-ess suggesed by Davidson and McKinnon (1981). This is an specificaion es for non-nesed models ha consiss in arificially building a nesed model ha comprises he non-nesed alernaive specificaions. The es consiss in inroducing in one of he specificaions (call i he iniial specificaion) he fied values from he oher specificaion (he alernaive) as an addiional explanaory variable. Under he null hypohesis ha he iniial specificaion is he correc one and ha he alernaive does no conain any addiional informaion, he esimaed coefficien on he fied values of he alernaive specificaion should be zero. One can hen perform he opposie analysis and inroduce in he alernaive specificaion he fied values from he original specificaion as an addiional explanaory variable. Under he null hypohesis ha he alernaive specificaion is he correc one, he esimaed coefficien on he fied values of he original specificaion should be zero. One of he drawbacks of his J-es is ha since we have wo null hypoheses, he resuls can be inconclusive. We can rejec boh nulls, i.e. boh specificaions conain informaion beyond wha is explained by he oher specificaion, or we can fail o rejec boh of he null hypoheses, i.e. neiher specificaion conains informaion beyond wha is conained in he alernaive one. The resuls from he J-es are repored in able 1 for all he combinaions of indusry and counry in our sample. The es rejecs he hypohesis ha he specificaion of he inegraed marke does no explain he specificaion of he segmened marke in over 50% of he cases. The es can only rejec he specificaion ha he segmened marke specificaion does no explain he inegraed marke specificaion in 5% of he cases (7 ou of 140). For he res of he cases, he es is inconclusive. In 56 insances, he J-ess rejecs boh null hypoheses, i.e. ha one specificaion does no explain he oher specificaion. This endency o rejec he null hypoheses oo ofen is one of he well-known weaknesses of his es in finie samples (see MacKinnon, 1992). Fisher and McAleer (1981) and Godfrey (1983) propose o do a simple adjusmen o he iniial es and o perform a similar es J A which has much beer finie-sample properies under he null han he ordinary J es. 12 The resuls from his es are presened in able 2. Again he evidence indicaes ha he inegraed marke specificaion seems more appropriae. The es rejecs he hypohesis ha he 12 The difference beween his es and he J-es lies in how he fied values o be used as an addiional regressor are esimaed. The esimaed fied values of he alernaive specificaion in he J A es are hose resuling from he esimaion of a regression in which he dependen variable is he fied values from he iniial specificaion and he exogenous regressors are hose of he alernaive specificaion. 12

13 inegraed marke does no explain he segmened marke specificaion in 60 insances, while he opposie happens in only 8 insances. We conclude from his evidence ha he specificaion ha assumes he exisence of an inegraed world marke and uses he U.S. dollar as he non euro currency which is relevan for rade is he mos appropriae model. 13 The kind of reasons for which he model formulaed in he effecive erms variables does no work properly can be seen mos inuiively in he case of produc 3 from he SITC (Mineral fuels). This is mainly composed of hydrocarbons. The marke for such producs (hink abou oil) is a highly inegraed one in which prices are seled in US dollars and rade is invoiced in his currency. Then, for a counry belonging o EMU, he flucuaions of is currency which will be relevan when rying o assess he degree of pass-hrough will be hose agains he US dollar and no hose agains he currencies of oil exporing counries (usually, developing counries, say, Saudi Arabia or Iran). In fac, for his paricular indusry, here is a large variey of exchange raes regimes among exporing counries. These regimes are ofen characerised by sysems of muliple exchange raes and associaed impor and capial conrols and regulaions, usually enailing a large degree of complexiy 14. Developmens in he exchange rae series resuling from such regimes do no necessarily have an impac on he prices of he impors made by developed counries. We perform he esimaion of equaion (4) by ordinary leas squares and esimae he shor-run and long-run pass-hrough elasiciies for all he differen indusry/counry combinaions. The values of hese esimaed elasiciies are repored in Table A1 in he appendix. In he shor-run, exchange rae pass-hrough is posiive bu incomplee. Columns wo and hree of able 3 repor he esimaed shor-run and long-run pass-hrough elasiciies when he resricion ha hese elasiciies are he same for all indusries wihin a given counry are imposed. In he shor-run passhrough is clearly incomplee. Indeed, boh he hypoheses of zero pass-hrough and complee pass-hrough can be rejeced for all counries in he sample excep Spain. The shor-run elasiciies are larger for Spain, Ialy and Finland and smalles for Ausria and Greece. In he long-run pass-hrough is much larger. The hypohesis of complee pass-hrough can only be rejeced for Ausria, Germany and Ireland. On 13 We use wo addiional crieria for model selecion: he Akaike Informaion Crierion and he Schwarz Bayesian Crierion. Boh of hese confirmed he resuls from he J-es ha he inegraed model specificaion fi he daa bes. 14 For insance, Iran had a sysem of muliple exchange raes unil On he oher hand, Saudi Arabia and he remaining Gulf counries have been pegging heir currencies o he US dollar from he early or mid eighies. 13

14 average for he euro area, shor-run pass-hrough is 0.61, while he esimaed longrun rae is Esimaed pass-hrough coefficiens vary by indusry. A zero shor-run passhrough can be rejeced for a large majoriy of indusries (Table 3, columns 4 and 5). Across counries, zero pass-hrough can be rejeced for more han 70% of he indusries in six of he eleven counries (France, Belgium, Neherlands, Germany, Ialy, and Spain). For Ireland and Greece zero pass-hrough is rejeced for only 25% of heir indusries. However, pass-hrough is clearly incomplee in he shor run. For all he counries in he sample, excep Finland, complee pass-hrough could be rejeced in a leas 45% of he indusries. In he long-run, pass-hrough is much higher and basically no differen from one. A long-run pass-hrough of one could no be rejeced for more han one indusry in seven of he eleven counries in he sample (las wo columns of Table 3). Only for France and Germany we do find sligh evidence ha long-run pass-hrough migh be less han one. For boh counries, he hypohesis of complee pass-hrough could be rejeced in 31% of heir indusries. This evidence of incomplee pass-hrough for larger counries is consisen wih some of he micro evidence ha suggess ha pricing-o-marke and incomplee pass-hrough are more common for expors o large counries (Kneer 1993 and Yang 1997). The esimaed elasiciies also differ by ype of produc. We esimae he pass-hrough elasiciies by imposing he resricion ha hey are equal for a given indusry across he eleven counries in he sample (columns wo and hree of able 4). These esimaed indusry elasiciies vary from a low of 0.40 for Elecric and elecronic machinery, o values above 0.80 for primary commodiies such as Food and live animals, Oils, fas and waxes and Mineral fuels, and also for he indusry producing Precision equipmen. Again, pass-hrough ends o be complee in he long run. A pass-hrough lower han one in he long run can only be rejeced for Elecric and elecronic machinery and Home equipmen and clohing. The equaliy of pass-hrough elasiciies across counries for a given indusry and wihin a counry for he differen indusries is of considerable ineres. The empirical micro evidence suggess he exisence of a large exen of inernaional price discriminaion. However, mos of his lieraure concludes ha he degree of pass-hrough is primarily indusry-specific and fairly consan for a given indusry across counries (Goldberg and Kneer, 1997). Campa and Goldberg (2002) also 14

15 conclude ha pass-hrough raes have been sable in ime and are consan for a given indusry across counries. They poin ha mos of he observed variaions in aggregae pass-hrough raes over ime in a counry can be explained by changes in he produc composiion of impors. Many of he curren lieraure in inernaional finance also emphasizes macro phenomena as a key driving source for pass-hrough raes wihin a counry (Devereux and Engel 2001). We have performed ess for he equaliy of pass-hrough raes across counries and indusries (able 5). Shor-run pass-hrough raes differ subsanially. In general, we can rejec ha pass-hrough raes in he shor-run are equal for all indusries wihin a given counry and for a given indusry across he eleven counries in our sample. In he long run, pass-hrough raes end o converge. Saisically, i is difficul o rejec he null hypoheses ha hey are consan for a given indusry or across indusries in a given counry. The equaliy of long-run elasiciies can only be rejeced for Greece. This lack of rejecion is no surprising given ha, as discussed above, long-run pass-hrough raes are no saisically differen from one in mos cases. The creaion of he moneary union implies a change in he proporion of impors and oal sales in each EMU marke ha is exposed o exchange rae movemens. The lieraure on he deerminans of exchange rae pass-hrough srongly emphasizes he marke share of domesic and foreign producers (i.e. he proporion of he marke ha is subjec o an exchange rae change) as one of he key deerminans of he pass-hrough elasiciy. The creaion of he euro has significanly changed his proporion. Prior o he inroducion of he euro a home currency depreciaion increased he relaive price of impors boh from curren noneuro and euro members. Afer he creaion of he euro, only he share of impors coming from ouside he area is affeced by a euro depreciaion. We have esed for he ime sabiliy of he esimaed parameers in our specificaion. We performed his es by assuming ha a break migh have aken place in May 1998, he monh in which he decision o fix permanenly he exchange raes among he euro consiuen currencies was aken. We could no rejec in mos insances he hypohesis ha he parameers were sable. Given he shor lengh of he subsample period afer ha dae, we also performed ess proposed by Andrews (1993) and Andrews and Ploberger (1994) o check for he exisence of an 15

16 endogenous break any ime during our sample period. 15 We only found some saisical evidence for four counries ha a srucural break migh have occurred during he fall of 1998 in he oil indusry. This srucural break was mos probably primarily driven by he large swing in he world price of oil during ha period raher han having any link o he creaion of he single currency. Also in his case, four insances of a break were found which, for a oal of 140 counry/indusry combinaions, lies wihin wha shoul d be saisically expeced a he 5% confidence level. We conclude from his evidence ha a srucural break has no occurred sysemaically during our sample period. V. IMPLICATIONS FOR DIFFERENTIAL EFFECTS IN AGGREGATE INFLATION RATES WITHIN A MONETARY UNION In his secion, we aemp o provide a firs grasp o he differenial impac ha movemens in he exchange rae of he euro can have on aggregae indicaors of inflaion across counries. We will focus on wo simple exercises: wha is he passhrough of exchange raes movemens ino he aggregae consumer price index of a counry (due o goods impored for final consumpion) and wha is he pass-hrough ino he overall coss of producion (due o impored inpus). More precisely, an approximaion o he aggregaed ransmission of exchange rae movemens o overall coss of producion and o consumer prices can be compued hrough some weighed aggregaion of he pass-hrough raes obained for he impor prices of each ype of produc. Our wo simple accouning exercises in his secion inend o be suggesive of he degree of differenial impac among he members of he euro area ha can accrue due o he heerogeneiies in he srucure of heir inernaional rade. The objecive here is neiher o idenify he primary sources of hese differenial effecs nor o draw any policy implicaions for he presence of hese differenial effecs. The goal is much more modes and mainly saisical. We hope o ge a broad sense on wha is he size of hese effecs (if hey do exis a all) and o deermine wheher heerogeneous rade srucures seem o be a relevan source of inflaion differenials wihin he euro area. The evidence found in he previous secion suggess ha, in he long run, he equaliy of pass-hrough raes o impor prices canno be rejeced neiher across he differen indusries of a given counry nor for he same indusry across counries. 15 We compued he hree differen ess proposed by hese papers and compued he p-values for he ess following he mehod proposed by Hansen (1997). Hansen (2001) provides a good survey of his lieraure. 16

17 These findings sugges ha differenial pass-hrough raes across counries due o indusry composiion are no likely o be big. However, our evidence also suggess ha pass-hrough was beer capured by an specificaion ha allowed for he presence of an inegraed world marke in each indusry raher han for he presence of a se of markes segmened by counry of origin and desinaion of he producs being raded. This emphasis on he imporance of indusry srucure is consisen wih some of he previous evidence suggesing ha exchange rae pass-hrough is an indusry phenomenon. This lieraure highlighs indusry srucure characerisics such as he number of compeiors, he inernaional locaion of he compeiion and he degree of imperfec compeiion presen in each indusry as imporan deerminans of indusry pass-hrough raes (Campa and Goldberg (2001), Kneer (1993)). On hese grounds and given our ineres in assessing o wha exen possible differences in overall pass-hrough raes are due o an heerogeneous indusry composiion of rade across counries, we have used for our analysis below he poin esimaes of long-run pass-hrough for each indusry (imposing equaliy across counries). To esimae hese effecs le us sar by conceiving a price index (eiher for consumer prices or for he aggregae coss of inpus) for counry i belonging o he euro area as he resul of wo successive decomposiions. The firs decomposiion allows us o express he price index as a weighed average of he differen producs enering he index: i, j i i,j w PI (p ) = (5) j where w i,j is he weigh of he produc caegory j in he aggregae index of counry i. Nex, we furher disaggregae he componen referring o each produc caegory ino hree subcomponens, which are defined according o he geographical origin of he producs. These hree produc subcaegories are a domesic produc, a produc impored from anoher euro area member counry and a produc impored from ouside he euro area. Therefore, as a resul of his second decomposiion, we can express he price index of counry i as = i, j i, jd i, je i, jn i i,j w i, jd w i,je w i,jn w (p ) (p ) (p ) (p ) j jd je jn PI = (6) 17

18 where he superscrips jd, je, and jn indicae for produc caegory j, he shares of is final or inermediae consumpion which are respecively saisfied by producs produced domesically, in oher euro area counries and in non-euro area counries. Taking firs differences of he logs of ha expression and assuming ha he weighs are consan over ime we obain ha i Π = jd i,jd i,jd w Π + w Π + w Π (7) je i,je i,je jn i,jn i,jn where Π does no sand any more for he produc operaor bu for inflaion. The effec on aggregae prices can be decomposed in he sum of hese hree caegories. A lower bound of he effec of exchange rae changes on inflaion is obained by considering only he effec due o he las erm of he righ hand-side of he equaion and by assuming ha he oher wo are zero. This is he direc effec arising from he pass-hrough o he prices of producs impored from ouside he euro area, i.e. assuming ha pass-hrough o prices of goods produced domesically and in oher euro area counries is zero. The shares of impors from ouside he area wihin oal impors have been obained using he inpu-oupu ables for each counry (for a dae as close as possible o 1995) and he Comex exernal rade daabase. In paricular, in he case of inermediae consumpion, he inpu-oupu ables show, for every indusry producing final goods, he decomposiion of inermediae consumpions beween hose which are domesically produced and hose ha are impored. Similarly, in he case of consumpion goods, he ables show which par of he demand for each produc is saisfied hrough domesic producion and impors. However, among impored producs, wha he ables do no show is he decomposiion according o heir origin (oher euro area economies vs. hird counries). I is a his poin ha he Comex daabase is used, since i offers, for our hireen produc caegories, he shares of impors coming from ouside he area wihin oal impors. Since he degree of produc disaggregaion in he inpu-oupu ables is much larger, i has been necessary o mach hem wih he 13 caegories obained form Comex. Besides, given he lack of more deailed informaion, we needed o make he assumpion ha, for each good enering he producion process as inermediae consumpions, he share of impors originaed ouside he area wihin oal impors is he same for all he 18

19 indusries producing final goods. The same assumpion is made when he produc eners final insead of inermediae consumpion. As previously saed, our exercise has been performed for wo differen price indices: he consumer price index and he price index of he producs used as inermediae inpus in he producion process. The resuls, which appear, respecively, in Figures 3 and 4 refer o he impac of a 10% depreciaion of he exchange rae of he euro. Since we have imposed ha, for a given indusry, passhrough raes o impor prices are he same across counries, divergences in passhrough raes o aggregae price indices can be due o wo sources. Firs, hey could be due o he differences in he degree of openness of he member counries (assuming ha he composiion of impors were he same for all counries). Second, for a given degree of openness, differences in he produc composiion of impors can also resul in differences in aggregae pass-hrough if produc-specific pass-hrough raes vary a lo by indusry. We will disinguish beween hese wo effecs by esimaing he pass-hrough raes wih each counry's own degree of openness and by imposing he same degree of openness (he average for he euro area) in all counries. The esimaed pass-hrough raes o he aggregae cos of inermediae inpus are depiced in Figure 3 for he EMU member counries. Ligher-colored bars correspond o he aggregae raes calculaed for each counry under is own degree of exposure o non-euro area impors (wha we have called degree of openness). Thus, observed differences in he size of hese bars beween counries are boh he resul of he heerogeneiy in he degree of openness and in he indusry composiion of rade. Conversely, darker-coloured bars are calculaed by imposing ha he degree of openness of all counries is he euro area average. Thus, remaining differences in he dark bars across counries are solely due o he heerogeneiy in he srucure of heir impors of inpus. Consider firs he ligh-colored se of bars. The average aggregae passhrough rae ino he oal coss of inermediae producion afer a 10% euro depreciaion is 1.2 for he euro area. By counry, Ireland, Belgium and he Neherlands show he highes raes of pass-hrough. In paricular, Ireland s passhrough of 2.3 is by far he larges, almos doub ling he European average. A he oher end, Ialy, Porugal and Spain have he hree lowes pass-hrough raes, all of hem below 0.8%. 19

20 Turning now o he darker bars in figure 3, differences in esimaed passhrough are much smaller. In his case, differences in pass-hrough raes across counries are due o differences in he produc composiion of impors of inpus semming from ouside he area. In paricular his shows ha Ireland s high passhrough rae is mainly due o is higher degree of openness o non-euro area impors. The range goes from a high of 1.3 for Porugal o a low of 0.8 for he Neherlands. Porugal, Greece and Ausria have slighly larger raes, suggesing ha hey end o impor producs wih higher pass-hrough elasiciies, w hile he Neherlands and France show he lowes esimaes. The esimaed pass-hrough raes o consumer price indices are much lower han o coss of producion (see figure 4). On he face of a 10% depreciaion of he euro exchange rae, he average pass-hrough rae for he euro area is below 0.5. Compared o he case of inermediae consumpion, his lower rae of pass-hrough is no surprising. Impored producs have a lower weigh in he baske of final consumpion producs ha in oal inermediae inpus used in producion. Nonradable producs play a much more imporan role in he consumer price index. Neverheless, he same paern ha we saw for producion coss applies o consumer prices. Differences in aggregae raes of pass-hrough are mainly due o divergences in he degree of openness o impors originaing in non-euro area counries. Under heir own degree of openness (ligh-colored bars), Ireland and Belgium show again he highes levels of exchange rae pass-hrough, while Ialy, France and Spain have he lowes. Again, differences among counries almos disappear once we impose ha hey all have he same degree of openness (dark bars). Porugal and Ausria are again among he counries which have a produc composiion of exra-emu impors in consumer goods ha leads hem o slighly higher pass-hrough raes, while Finland, Germany and he Neherlands have lower raes. The overall range is quie small, from a high of 0.48 for Belgium o a low of 0.24 for Finland. One furher sep is o deermine o wha exen he calculaed differences in oal pass-hrough raes are saisically significan. Tables 6 and 7 presen he ess of equaliy of he calculaed pass-hrough raes agains boh heir weighed and unweighed averages (being he weighs he relaive size of each counry's GDP wihin he GDP of he oal area). Tesing agains he unweighed average has he poenial disadvanage ha, in he case ha a small counry would have a oal pass- 20

21 hrough rae which is much differen f rom he ohers, he unweighed average would end o be biased owards he pass-hrough value for ha counry, so ha he equaliy of oal raes o heir average would end o be rejeced for he oher counries, while in fac, apar from he oulier, pass-hrough raes could be clusered around a small range of values. On he oher hand, he weighed average could pose an analogous problem whenever he oulier is a very large counry and all oher counries show similar values among hem. Table 6 shows ha, whenever oal pass-hrough raes o he cos of inermediae consumpion are calculaed using he own degree of openness of each counry, he equaliy of oal pass-hrough raes is rejeced nearly always, regardless wheher his is esed agains eiher he weighed or he unweighed average. However, when he same degree of openness is imposed, he equaliy of oal passhrough raes o heir average can no be saisically rejeced in nearly all cases. In paricular, his shows ha he comparaively very high Irish rae is due o he large reliance of his economy on impored inpus while, on he oher hand, he Ausrian and Poruguese economies producion processes are relaively more inensive in he use of inermediae consumpions whose price shows a larger exchange rae elasiciy. Table 7 repors he resuls of he analogous exercise for he case of final consumpion. F ess performed for oal pass-hrough raes calculaed under each counry's own degree of openness show again ha, only in a few cases, he equaliy o he (weighed or unweighed) average canno be rejeced. When i is imposed ha he share of impors wihin final consumpion is he same for all counries, he null hypohesis fails o be rejeced for a higher share of counries. However, i is ineresing o noice ha his share of non rejecions is lower ha in he case of inermediae consumpion, poining ou owards he fac ha he srucure of he laer across euro area counries is more similar han for final consumpion. In paricular, he impor srucure of privae consumpion seems o be consisenly differen in erms of exchange rae sensiiviy when compared o he area average in he cases of Belgium-Luxembourg, Porugal and Ausria. The effec idenified in his secion should be considered only a lower bound on he likely impac of exchange rae movemens in final consumer prices. Prices of domesically produced goods and of goods impored from oher euro area counries compeing wih impors from ouside he area are likely o move in direc response o 21

22 he behaviour of he prices of he laer. Furhermore, o he exen ha domesic goods and impors from he euro area use impored producs from non-euro counries as inpus in heir producion process, heir producion coss will move in he same direcion as he price of non-euro impors. This change in producion coss for hese goods will also probably be ransmied ino he price of he final produc. These kind of indirec effecs have no been aken ino accoun in our exercise. Neverheless i seems unlikely ha accouning for hese effecs will subsanially aler he basic resul, mainly ha differences in aggregae pass-hrough raes across counries are primarily driven by differences in he degree of openness o non-euro rade. VI. CONCLUSIONS This paper has focused on he pass-hrough of exchange rae changes o prices of exra-emu impors ino he welve counries ha are he curren members of he euro area. The member counries differ subsanially in heir exposure o impors from non-euro area counries boh in erms of he degree of openness o non-euro impors and in he produc composiion of hese impors. We have focused on impors from non-euro area member counries since his is he par of he oal rade of he counries which has coninued o be exposed o exchange rae flucuaions afer he creaion of he euro zone in We have used ime series daa on impor uni values for hireen differen produc caegories for each counry. The empirical evidence suggesed ha inernaional goods markes are fairly inegraed. An empirical specificaion ha allowed for he presence of an inegraed world marke fied he daa beer han an specificaion allowing for he presence of a se of segmened markes by counry of origin and desinaion of he producs being raded. Exchange rae pass-hrough is incomplee in he shor-run. Average passhrough in he shor run is around 0.6. Pass-hrough increases in he long-run, when he hypohesis of 100% pass-hrough canno be rejeced for he majoriy of indusries. Furhermore, long-run pass-hrough raes do no differ significanly across counries or indusries. Movemens in he euro exchange rae have differen effecs in he evoluion of aggregae prices in he member counries. Ireland, followed by Belgium and he Neherlands, experience a quie larger impac on aggregae prices from movemens 22