We analyze exchange rate pass-through, i.e. the change in local currency prices resulting from variations in the exchange rate, for consumer prices in the euro area. We first estimate country-specific pass-through coefficients for five large countries of the euro area (Germany, France, Italy, Spain and the Netherlands) using time series data for the past 20 years. Following this we construct a weighted average of these coefficients using the weight of each country in the Harmonized Index of Consumer Prices (HICP). As Menon (1995) in a comprehensive survey of the relevant literature points out, former empirical studies of exchange rate pass-through focus largely on the US and often neglect the time series properties of the data. To our knowledge, Ranki (2000) is the only source so far that analyzes data for the euro area. Furthermore, many recent studies analyze the pass-through to import prices of different products on the micro level rather than focussing on the effects of aggregate price measures like consumer price indices. We contribute to the existing literature in several ways. First, our study presents one of the first estimates of the effects of changes in the euro exchange rate on the Harmonized Index of Consumer Prices (HICP) in the euro area. Second, we estimate Vector Error Correction Models to take account of the non-stationarity of most of the used variables and cointegration relationships between them. Third, while a large part of the literature in the past years has focussed on the question "why" there is incomplete pass-through to import prices we present quantified effects on aggregate consumer price indices. Thus, our study is in the spirit of Kim (1998) and McCarthy (2000) who tackle related questions for other markets (Kim (1998) studies the US market) or use different econometric methods (McCarthy (2000) who applies Vector Autoregression) and is of direct relevance for monetary policy makers. Since aggregated time series data for the euro area are only available from 1999 on we estimate exchange rate pass-through for five large EU-countries separately and then compute an average for the euro area using the relative weight of each country in the HICP. Our country sample includes Germany, France, Italy, Spain and the Netherlands which together represent about 86 percent of the influence on the HICP. Thus, we believe our results are a rather robust estimate of the exchange rate influence. Our study uses monthly data from 1981 until 2001 and includes as variables nominal national effective exchange rate indices, short-term interest rates, output gaps constructed from industrial production, the oil price and all three stages of the distribution chain: import, producer and consumer prices. After performing unit root tests we cointegration relationships between the variables for each of the countries used in our sample. Thus, we estimate Vector Error Correction Models for the five countries and generate impulse-response functions in order to quantify the effect of an exchange rate shock on consumer prices. Regarding the country specific results we find that the Netherlands exhibit the fastest pass-through of exchange rate changes to consumer prices, but the long run effects are highest in Italy and France. Pass-through coefficients, i.e. the share of exchange rate change that is reflected in consumer prices, ranges from 7 (France) to 12 percent (Italy) after one year. After two years, coefficients range from 8 (Spain) to 18 percent (Italy). As expected, the extent of pass-through declines along the distribution chain with the largest effect occurring in import prices. By computing the variance decompositions for each country we obtain a relative ranking of the magnitude of the exchange rate effect across countries for the explanation of price changes. The largest fraction of import price changes explained by exchange rate changes is found in Germany, the Netherlands and France. The effect on producer prices is relatively large in the Netherlands, Spain and Germany and the Netherlands and France exhibit the strongest impact on consumer prices. Along with the existing literature we explain the stronger impact in the Netherlands with their import share which is the largest among the five countries in our study. Aggregating the national results using the relative weights of each country's inflation rate in the HICP we find that on average a ten percent depreciation of the effective euro exchange rate leads to an increase of 0,4 percentage points in the euro area inflation rate after one year. The total effect converges to 0,8 percentage points after about three years. This amounts to an exchange rate pass-through to consumer prices of 8 percent of the initial exchange rate shock. The result shows that the euro exchange rate does have an effect on consumer price inflation in the euro area and thus needs to be taken into account by the monetary authorities.
Articles in Refereed Journals
Hüfner, Felix and Michael Schröder (2003), Exchange Rate Pass-Through to Consumer Prices: A European Perspective, Aussenwirtschaft - The Swiss Review of International Economic Relations 58, Heft III, 383-411.
Discussion and Working Papers
Hüfner, Felix and Michael Schröder (2002), Exchange Rate Pass-Through to Consumer Prices: A European Perspective, ZEW Discussion Paper No. 02-20, Mannheim. Download
20.03.2001 - 31.01.2002