Which would decrease the exchange-rate pass-through?

Question

BlackTom AI · Accepted Answer

Exchange-rate pass-through (ERPT) measures how much a change in the exchange rate (typically domestic currency per unit of foreign currency) is reflected in local-currency prices of traded goods. Two key concepts matter: invoicing currency (whether exporters set prices in their own currency or the buyer’s currency) and strategic price setting/markup adjustment by firms.

Step 1 — Relevant knowledge points:
- If firms invoice in the buyer’s (local) currency, exporters must change listed prices when the exchange rate moves unless they absorb exchange-rate effects in profit margins. That tends to raise ERPT.
- If firms invoice in a foreign currency (producer-currency pricing) but can adjust their foreign-currency price or margins to protect demand, the pass-through into local-currency consumer prices can be reduced.
- Strategic pricing (preserving market share, flexible markups, distribution costs) affects how much of an exchange-rate change is passed on.

Step 2 — Reasoning and numeric illustration:
Assume a foreign exporter posts a price P* = 100 (foreign currency units). The exchange rate e is domestic currency per 1 foreign unit. Domestic price = P_local = e × P*.
- If e = 1.00, P_local = 1.00 × 100 = 100.
- If e rises to 1.10 (domestic currency depreciation by 10%) and the exporter leaves P* unchanged, P_local = 1.10 × 100 = 110, i.e., full 10% pass-through.
- But if P* is set in foreign currency yet the exporter reduces P* to 95 to protect sales, P_local = 1.10 × 95 = 104.5, a 4.5% increase only. The exporter absorbed part of the exchange-rate change by cutting the foreign-currency price and/or margins, so ERPT into domestic prices fell from 10% to 4.5%.

Step 3 — Why the correct option is correct:
When “more prices and costs are denoted in foreign currencies,” firms increasingly invoice and incur costs in foreign currency. That situation encourages exporters to adjust their foreign-currency prices or margins to maintain competitiveness in the local market rather than letting domestic prices move one-for-one with exchange rates. As the numeric example shows, by adjusting foreign-currency prices and absorbing part of the effect in margins/distribution, the pass-through into local-currency prices is reduced. Thus ERPT decreases.

Step 4 — Why the other options are incorrect:
- “Lower share of distributional costs”: lower distribution margins reduce frictions and can make it easier to change final prices, often increasing pass-through rather than decreasing it.
- “Less concern with market preservation”: if firms care less about protecting market share, they are more likely to pass exchange-rate changes to buyers (higher pass-through), not lower it.
- “All of these”: because the first two items do not reduce ERPT (they tend to increase it), “all of these” is wrong.

Conclusion: The factor that decreases exchange-rate pass-through among the choices is “more prices and costs are denoted in foreign currencies,” which matches the provided correct answer.

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