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

Question

BlackTom AI · Accepted Answer

Exchange-rate pass-through (ERPT) measures how much domestic prices change when the exchange rate changes. A standard pricing model helps explain why ERPT fell after the 1990s.

1. Relevant knowledge points and concepts
- ERPT = percentage change in domestic prices resulting from a 1% change in the exchange rate.
- Determinants of ERPT include market structure/competition, invoicing currency and pricing-to-market, the use of hedging and financial instruments, global value chains, and the degree of product differentiation.
- Increased competition reduces firms’ ability to raise prices when costs rise; they tend to absorb cost changes by cutting markups.

2. Step-by-step reasoning
Start with a simple pricing relationship in domestic currency:
Pd = e * Pf + μ
where Pd = domestic price, e = exchange rate (domestic per foreign), Pf = foreign-currency producer price, μ = markup. Differentiate with respect to e:
dPd/de = Pf + dμ/de
Divide by Pd to get pass-through elasticity:
ERPT = (e/Pd) * (Pf + dμ/de)

If markup μ is fixed, dμ/de = 0 and pass-through is high (close to 1 if Pf dominates). Under stronger competition, firms adjust μ downward when e rises (dμ/de < 0), so the term Pf + dμ/de is smaller and ERPT falls.

3. Intermediate calculation example
Assume Pf = 1, initial Pd = e*1 + μ. If μ responds to e such that dμ/de = −0.6 and Pf =1, then effective numerator = 1 − 0.6 = 0.4; pass-through ≈ 0.4 (40%). If competition was weaker (dμ/de = −0.2), pass-through ≈ 0.8 (80%). This shows how stronger competition (larger negative dμ/de) lowers ERPT.

4. Why the correct answer is correct
The option “higher degree of competition” directly captures the mechanism: more intense competition forces firms to absorb exchange-rate-induced cost changes via smaller markups, reducing observable pass-through into final prices.

5. Why other options are incorrect
- “Lower international trade in services”: trade in services generally increased after the 1990s; moreover, services trade changes are not the main driver of goods price ERPT decline.
- “Lower global integration”: globalization and global value chains increased since the 1990s, which would tend to change pass-through but not in the “lower integration” sense.
- “All of these”: since the other two are incorrect, “all of these” is wrong.

6. Conclusion
Higher degree of competition explains the decline in exchange-rate pass-through since the 1990s; this matches the provided correct answer: higher degree of competition.

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