A Structural Approach to Identifying the Sources of Local Currency Price Stability

Abstract

The inertia of the local currency prices of traded goods in the face of exchange rate changes is a well-documented phenomenon in International Economics. This paper develops a structural model to identify the sources of this local currency price stability and applies it to micro-data from the beer market. The empirical procedure exploits manufacturers' and retailers' first-order conditions in conjunction with detailed information on the frequency of price adjustments following exchange rate changes to quantify the relative importance of local non-traded cost components, markup adjustment by manufacturers and retailers, and nominal price rigidities in the incomplete transmission of such changes to prices. We find that, on average, approximately 60% of the incomplete exchange rate pass-through is due to local non-traded costs; 8% to markup adjustment; 30% to the existence of own brand price adjustment costs; and 1% to the indirect/strategic effect of such costs, though these results vary considerably across individual brands according to their market shares.