Long Run Exchange Rate Pass-Through
Eliseev A., Novak A., Shulgin A.
Various empirical findings suggest that the short-term exchange rate pass-through to prices is quite low. However, can we extrapolate this conclusion to the long term? According to the results of our study, no. To show it, we developed and estimated the static general equilibrium model which includes two effects of real price rigidity for explaining the incompleteness of long-run exchange rate pass-through. The first effect is the distribution markup: domestic nominal currency depreciation leads to a decrease of the share of distribution costs in price, which increases the elasticity of demand, and, therefore, reduces the markup on imported goods. The second one is the ad hoc effect of market share: unlike foreign firms, nominal exchange rate depreciation gives an opportunity for domestic firms to expand its market share through a moderate increase of their prices.
Our contribution to the empirical part is that we conducted the model estimation in two stages uses long term data from one country (Russia). Firstly, we estimated the distribution margin using the data from 80 regions of Russia for the period of 2012-2018. The long-run exchange rate pass-through into the import prices is 92.7% (excluding distribution margin). Our estimate of the distribution margin is 30.5%; while the markup is 25.9% and the degree of regional bias in consumption is 8.9%.
Secondly, we estimated the remaining model parameters applying the Russian macroeconomic data. The estimated markup of domestic firms decreases by a one third of the domestic currency depreciation. Contrary, a high estimate of the elasticity of substitution between domestic and foreign traded goods (3.8), low elasticity of intertemporal substitution (1/1.9) and low Frisch elasticity of labor supply (1/6.4) lead to a secondary effect via wage increasing. A decrease in the domestic goods relative prices causes an increase in employment and consumption, while the latter results in the rise of wages. This effect almost completely compensates the initial effect.
Our estimate of the total exchange rate pass-through into prices is 98.5% on the long-term horizon (more than 5 years). We demonstrated the robustness of this result to alternative prior distributions as well as the different magnitude of the market share effect.