Research Brief

Measuring the Impact of Currency Moves on Consumer Prices

It varies across goods and services and can be blunted by monetary policy

If the U.S. dollar declines 20% relative to the Japanese yen, then prices of new cars made in Japan and exported to the U.S. could be expected to rise by 20%. However, Toyota may decide to absorb part of the price increase to keep its prices competitive with cars made in the U.S.

If the exporter absorbs half of the increase caused by the exchange rate change, then prices only rise by 10%. Exchange rate pass-through measures how much of a change in the exchange rate is reflected in the prices of imported and exported goods. (In this case, the ERPT is 0.5 because only 50% of the actual increase caused by the exchange rate is passed through to the consumer.)

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For an economy like that of the U.S. with a stable currency and diversified manufacturing and service industries, ERPT may be a lesser concern. But for the many smaller countries with more volatile currencies and a lack of domestic production of many goods and services, keeping ERPT low can be crucial to containing inflation and maintaining standards of living.

The level of pass-through varies significantly from country to country and over time. And it differs across a country’s various goods and services that comprise its measure of inflation, like the U.S. consumer price index.

In a paper published in Open Economies Review, UCLA Anderson’s Sebastian Edwards and Luis Cabezas, a Ph.D. student, examine the relationship between ERPT for individual classes of goods and services and how easily those items can be traded internationally. Additionally, they examine how a nation’s monetary policy, in this case Iceland’s, affects ERPT.

Iceland’s Volatile Currency and Deep Dependency on Imports

To perform their analysis, the researchers used data for Iceland during 2003-2019. This period includes Iceland’s banking and currency crisis in 2008. Over the course of 2008, a single U.S. dollar went from purchasing roughly 60 Icelandic króna to purchasing 120, implying a doubling in the cost of U.S.-imported goods unless sellers swallowed some of the currency cost.

In addition to the plunge in its currency, Iceland was also of interest to the researchers because its central bank instituted a new monetary policy framework in 2009-2010. Previously, Iceland had relied on short-term interbank interest rates as its main policy tool and had a rigid inflation target of 2.5%. With its new policy, it introduced a flexible inflation target and managed the float of the exchange rate instead of allowing it to float freely.

A Detailed Look at Prices

Some previous studies used aggregate price data in their analysis of ERPT. For their study, Edwards and Cabezas employed detailed data on the prices of goods and services making up Iceland’s CPI. The granular data was necessary to be able to determine whether ERPT differed between categories of goods.

They found that ERPT was significantly higher for tradable goods, which can be sold in countries other than Iceland, like clothing and furniture, compared with nontradable services like education that had an ERPT in Iceland of essentially zero. The higher ERPT in the internationally tradable goods suggest that sellers passed through higher exchange rate costs to consumers while sellers of less easily tradable goods were willing to absorb more. Essentially, foreign sellers of goods that can be easily sold to many different countries, including countries not dealing with a currency devaluation, are less willing to cut prices than the sellers of goods with fewer alternative markets.

While the wider public may focus on a nation’s overall inflation rate — and on a handful of highly visible goods like gasoline and groceries — it benefits policymakers to understand the breakdown of items that make up inflation and its causes.

The Role of Monetary Policy

Edwards and Cabezas also found that the overall pass-through level declined around the same time that Iceland changed its monetary policy. The lower level of ERPT is a sign of increased confidence in the soundness of the new monetary policy. Expectations of continued inflation, whatever its causes, can cause consumers and businesses to continue to act in ways that increase inflationary pressures, such as seeking price or wage increases to offset expected future costs.

Past studies have estimated Iceland’s overall level of ERPT at roughly 0.4. This is higher than the level used for policy design and evaluation by many advanced nations. The researchers’ analysis arrived at a lower level for Iceland’s ERPT. They found Iceland’s ERPT to be 0.15 in the short run and in the long-term the level to be approximately 0.23. This means that a 10% depreciation of the króna would lead to a 2.3% increase in CPI inflation rather than the 4% previously thought.

This information can be valuable for businesses, consumers and policymakers as it can enable them to better estimate their costs amid future swings in their currency and potentially better judge the portion of a currency devaluation that sellers are willing to absorb.

Featured Faculty

  • Sebastian Edwards

    Professor of Global Economics and Management; Henry Ford II Chair in International Management

About the Research

Edwards, S., & Cabezas, L. (2022). Exchange rate pass-through, monetary policy, and real exchange rates: Iceland and the 2008 crisis. Open Economies Review, 33(2), 197-230.

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