The Price Puzzle of the Insensitivity of Consumer Prices - Essay Example

Introduction: It is strange and surprising that how pricing differs in some trades, defying the economic theories. Such a puzzle came across me as well while talking to and working closely with a relative involved in exporting business. If you ask a layman what the price of one commodity, imported to USA from China, would be and most probably the answer which you will get is the prices in dollars multiplied by the exchange rate and add the transportation cost and the profit margin. However, when I spoke to my relative, he gave me a rather unusual answer and said that the exchange rate has the least impact on the consumer prices of imported goods. I was puzzled by what the person answered me and did some secondary research on the topic. I was more surprised when I found a dilemma on the website that in Feb 2002, the price of dollar with respect to other currencies had dropped by 27% (Wincoop, Eric. 2002), yet, at the same time, the consumer prices increased at a much smaller rate of just 8.9% over the same period of time (Rogers, John. 1996). The relative insensitivity of consumer prices to exchange rates became a puzzle as it negates the international trade theory according to which if all goods and services are traded at their productions costs, neglecting all other costs, the retails prices should be responsive to exchange rate changes. Empirical Evidence: Theoretically speaking, all retail prices should be a reflection of the dollar cost of production of a good or service. If you neglect all the costs and assume that their markets are in perfect competition, then their prices would be very sensitive to the exchange rates. Take an example of a commodity being exported from China to USA; the price of the commodity in USA would simple be the Yuan price multiplied by the Dollar Yuan exchange rate. If the dollar depreciates against Yuan, the price of the commodity would rise in the same proportion. However, in practice, the price of goods is not sensitive to the exchange rates. According to a study , a 10% currency depreciation results in only a 6% increase in import prices and only 2% increase in consumer prices (Goldberg, Linda . 2006). Economists have given many possible solutions to this puzzle. According to their study, the reasons for this dilemma could consist of distance, non-traded goods and services and changing profit margins (Rebelo, Sergio. 2003). All these changes would cause a shift in the demand supply curve which could be a reason why exchange rates are not the core determinant of changes in prices. In the following sections, I will discuss these solutions in greater detail while trying to figure out the exact reason(s) for this puzzle. Exchange Rate Pass-through Elasticities into Import and Consumer Price Indices Country Pass-Through on Import Prices Pass-through on Consumer Prices Australia 0.67*+ 0.09+ Austria 0.1 -0.09 Belgium 0.08+ 0.08+ Canada 0.65* -0.01+ Czech Republic 0.6* 0.60*+ Denmark 0.82* 0.16*+ Finland 0.77 - 0.02+ France 0.98* 0.48*+ Germany 0.80* 0.07+ Hungary 0.78* 0.42*+ Ireland 0.06 0.08+ Italy 0.35+ 0.03+ Japan 1.13* 0.11*+ Netherlands 0.84* 0.38*+ New Zealand 0.22+ 0.10*+ Norway 0.63* 0.08+ Poland 0.78* 0.59*+ Portugal 1.08* 0.60*+ Spain 0.70* 0.36*+ Sweden 0.38*+ 0.11+ Switzerland 0.93* 0.17*+ United Kingdom 0.46*+ 0.11+ United States 0.42*+ 0.01+ Average 0.64 0.17 The above graph shows how the exchange rate affects the import and consumer prices in different countries. It is evident from the graph that there is a weak correlation between the exchange rate changes and the consumer prices. Some of the common reasons why the consumer prices are insensitive to exchange rates are as follows: 1. Distance: The most common reason why consumer prices are insensitive to exchange rates is the substantial costs involved in the transportation of the goods depending on the distance between the two countries. For example, if you export a commodity from China to USA, the higher price in USA of the commodity would be because of the added cost of transportation over the long distance. Now, if Dollar depreciates, the price of commodity in USA would increase, however, if the cost of transportation is substantial and is ineffective because of dollar depreciation, there would not be an effect on the cost of commodity in USA. However, according to a study, geographical distance is not the main determinant or relationship between consumer prices and exchange rate fluctuations ( Rogers, John. 1996). The study found that although cities in close proximity have lower transportation costs and their prices also move closely together, however, if the two cities belong to two different nations i.e there is a national border between them, this phenomenon does not hold true and the equivalent distance because of national borders ( as calculated by the study) could be upto 1700- 20,000 miles in explaining the prices between two countries( Rebelo, Sergio. 2003).. Thus, it seems that rather than physical distance, national borders play a more important role in explaining the consumer prices. 2. Non- traded goods or services: Another reason for consumer prices being insensitive to exchange rate movements is that some goods or services are not internationally traded at all at local level, however they add up to the cost when traded to another country. The retail price of many consumer goods include non-tradable goods and services, such as transportation, marketing, selling and distribution costs which may be intensive in one country but not in another. Therefore, distribution costs and other non tradable costs can increase the costs of consumer prices to a large extent, up to 40% in some cases ( Rebelo, Sergio. 2003). 3. Changing profit margins: In practice, many goods imported by a certain country enter an imperfect competitive market. Therefore, importing firms at times make a profit margin over costs due to their monopoly. At times, firms may not choose to pass on the full change of exchange rates to consumers; rather they choose to change their profit margins. As a result, consumer prices become less sensitive to exchange rates. Finally, we can also use the simple demand and supply concept to explain why exchange rates have a low impact on consumer prices. We can explain this concept by taking an example of a commodity and two countries, China and USA. Firms in China would be most interested in exporting their goods to USA if the domestic market is saturated and there is a lot of competition in the local market. As the demand of the commodity would decrease in the local market, the equilibrium price would shift down resulting in lesser margin for the suppliers; hence, they would look for foreign markets where the demand exists or if there is potential for a market niche. We can show the shift in demand in China using the following graph: Previous position of equilibrium price in China. Change in equilibrium price However, on the other hand, the reason why Chinese would be interested in exporting their commodity to USA would be either because they would have identified a new market niche or the demand for the commodity is high enough that local suppliers are unable to fulfill it. As a result, there is a gap in the equilibrium price due to shortage of supply. The equilibrium price would be high which can either be due to high demand, or low supply. The two scenarios can be graphically illustrated as follows: Increase in demand Decrease in supply If the demand is high enough, the suppliers in China or the importers in USA would ignore the exchange rates as they can nullify its effect even by adjusting their profit margins. So, consumer prices, or, in this case, even the import prices would be insensitive to the exchange rates. Conclusion: The price puzzle of the insensitivity of consumer prices to exchange rates astonishes economists as it goes against the theoretical concepts of international trade theory. Distance and costs of transportation can be regarded as a solution to this puzzle, but other reasons can also be used to solve this puzzle such as non tradable costs and profit margin adjustments and the supply and demand models which differ in two trading countries. References Wincoop, Eric. (2002). Why Do consumer prices react less than import prices to exchange rates?". NBER Working Paper, Retrieved from http://www.nber.org/papers/w9352.pdf Rebelo, Sergio. (2003). Distribution costs and real exchange rate dynamics during exchange-rate-based stabilizations. Journal of Monetary Economics Goldberg, Linda . (2006). Distribution margins, imported inputs, and the sensitivity of the cpi to exchange rates". NBER Working Paper, Retrieved from http://www.nber.org/papers/w12121.pdf Rogers, John. (1996). How Wide is the border. American Economic Review. Robert, Feenstra. (1998). Integration of trade and disintegration of production in the global economy. Journal of Economic Perspective. Diego, Valderrama. (2004). "does a fall in the dollar mean higher u.s. consumer prices?. FRBSF Economic Letter. Read More