Which helps explain why exchange-rate pass-through has declined since the 1990s?

Question

BlackTom AI · Accepted Answer

A higher degree of competition leads firms to absorb exchange-rate changes rather than pass them fully into final prices, which lowers exchange-rate pass-through (ERPT).

Relevant concepts: ERPT measures the percentage of an exchange-rate change that is reflected in import or consumer prices. Firms set markups over costs; the extent they adjust prices when costs (or exchange rates) change depends on market structure, demand elasticity, invoicing currency, and hedging.

Step-by-step reasoning:
1) Start with a pricing relation: domestic price P = e · c_f · (1 + μ), where e is the exchange rate (domestic currency per unit foreign currency), c_f is the foreign-currency marginal cost, and μ is the markup. Taking logs, d ln P / d ln e = 1 + d ln(1+μ) / d ln e. If μ is fixed, pass-through = 1 (full). If μ falls when e rises (firms cut markups to keep prices stable), the second term is negative and pass-through < 1.
2) Increased competition raises demand elasticity faced by each firm. More elastic demand forces firms to protect market share by reducing markups when costs rise, i.e., μ falls in response to higher e. That reduces d ln P / d ln e and thus ERPT.
3) Empirically since the 1990s globalization, entry of low-cost producers, growth of large retail chains and online platforms increased competition in many product markets. Firms responded by pricing more competitively, which led them to absorb exchange-rate movements into margins rather than pass them to consumers.

Why this is correct: the theoretical markup channel and empirical evidence both point to stronger competition reducing the incentive to shift exchange-rate-driven cost changes into prices, lowering pass-through.

Why alternatives (e.g., more hedging, increased local-currency invoicing, or lower inflation) are less central: these factors can affect ERPT but do not explain the widespread, persistent decline as broadly as intensified competition and market structure changes do.

Conclusion: The correct answer is higher degree of competition.

Which helps explain why exchange-rate pass-through has declined since the 1990s?Single choice

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