The Theory of Exchange Rate Pass-through

Abstract

This chapter pieces together the theoretical literature on the relationship between exchange rates and prices of traded goods. This is done to lay the groundwork for the development of models to be used to estimate the degree of exchange rate pass-through and explain inter-product differences in exchange rate pass-through. The discussion is organised so that the different factors that affect the relationship between exchange rates and prices are treated separately. This approach is necessitated by the fact that “there is no single coherent theory of devaluation (or revaluation) under imperfect competition, but rather an amalgam of reasons why prices may not respond fully to exchange rate changes” (Magee 1975:231). Furthermore, the discussion distinguishes between exchange rate pass-through in the short-run and the long-run. This enables us to separate the factors that affect the pace of adjustment of import prices to exchange rate changes from those responsible for a more persistent departure from the full pass-through outcome.