Over the last twenty years the United States has persistently ran a current account deficit, a deficit that concerns some economists for they consider it unsustainable (Edwards, 2006). Amongst the possible remedies is an exchange rate depreciation. In its most simple form, an exchange rate depreciation makes US exports more competitive (causing an increase in exports) and US imports more expensive (causing a decrease in exports), thus reducing the current account deficit. This all hinges on the exchange-rate pass-through, that is the extent to which changes in the exchange rate affect prices of imports. This paper examines the extent to which the exchange-rate pass-through for US imports has changed from 1990 to 2016 and finds that the exchange-rate pass-through for US imports has declined from 1990 to 2016 when relying on a log-linear model. However, those results are not replicated when using a linear model, raising the question to what extent we can rely on the log-linear model and its underlying assumptions in order to assess changes in the exchange-rate pass-through for US imports.
Given the substantial current account deficits the US has run there has been no lack of attention to the study of the exchange-rate pass-through. In the 80’s, Mann and Hooper (1989) noted that the exchange-rate pass-through is of importance to the potential of exchange rate depreciations to affect the US current account balance. Back then they found that the exchange-rate pass-through ranged from 50% to 60% and had remained stable over the decade – for manufactures that is. Campa et al. (2005), in a more recent study note that there are various explanations for swings in the exchange-rate pass-through – amongst them industrial organization, segmentation and price discrimination – and note that in more recent years the pass-through has seemed to decline.
Hellerstein et al. acknowledge the observation shared by Campa et al., namely that the exchange-rate pass-through is rumored to have declined. Most directly, this observation was inspired by the roughly 15% depreciation of the US dollar from 2002 to 2005 which had some economists expect a more pronounced improvement in the US current account balance. Yet Hellerstein et al. find that the decrease found by others, such as Marazzi et al (2005), is exaggerated, and point to choices in model design as possible explanators. It seems therefore fair to say that there is no clear consensus on the changes in the exchange-rate pass-through.
To drive home the relevance of this question outside of the realm of economists, a more recent example suffices. Following the 2016 Brexit referendum, in which the UK voted to leave the European Union – its biggest trading partner – the Sterling Pound witnessed a significant depreciation. Brexiteers, looking for a positive spin on this ominous sign of the markets, argued that a depreciation of the pound would boost exports. Yet exports did not boom, and the Brexiteers were proven wrong (The Economist, 2017). The exchange-rate pass-through, and the effect it had on rising import prices that are components to British exports, would have better informed Brexiteers of the potential (or lack thereof) boost in exports that would follow from a pound depreciation. Although not solely concerned with the exchange-rate pass-through, this example illustrates its lasting relevance to a recent economic phenomenon and the importance of the further study of this topic.
In order to add to the existing body of literature on the topic, this paper studies the changes in the exchange-rate pass-through for US imports. Specifically concerning itself with the period from 1990 to 2016. First, the methodology used is discussed. Second, the data concerned is described. Third, the regression results are presented. Lastly, the results are interpreted, conclusions drawn, and limitations discussed. Let’s get started with discussing the methodology.
Methodology
In order to study the changes in the exchange-rate pass-through, and to see whether there has indeed been a drop in the exchange-rate pass-through, this section sets out the methodology used and in doing so specifies the models used. The models used and the rationality behind them are especially important for this paper, seeing that there is ample discussion on the validity of the models used, let alone the results they produce.
Before diving into the specifics of the models used, let us make clear why multiple models are used. Previous work used models that relied on the assumption of a constant exchange-rate pass-through in order to obtain their econometric results. Yet when splitting their regressions over two or more periods, that work presented differing results, begging the question whether one of the assumptions of the model was violated (Ihrig et al., 2006). In order to assess the join hypothesis of (1) whether the US exchange-rate pass-through for imports has declined and (2) whether the results obtained follow from a model whose assumptions are valid, we use both a log-linear and linear model. In addition, we look at both short- and long-term effects.
Using both a log-linear (for multiple periods) and a linear model allows us to examine to what extent exchange-rate pass-throughs remain constant, an assumption underpinning the OLS estimation of the log-linear model. The log-linear model is formulated as follows:
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