The effect of exchange rates on prices, wages, and profits: A case study of the United Kingdom in the 1990s

Abstract

During the 1990s the United Kingdom experienced large and sudden exchange rate movements that had no apparent impact on overall consumer prices. This paper shows that the stability of UK consumer prices was made possible in part by offsetting movements in the price-cost margins of foreign exporters and in part by offsetting price-cost margins in the UK distribution sector. At the same time, UK manufacturers experienced margin swings in the opposite direction, largely due to their role as exporters. Thus, sterling depreciation boosted the profits of UK manufacturers and squeezed the profits of UK distributors, while sterling appreciation had the opposite effects.

Keywords:

• Appreciation
• depreciation
• operating surplus
• pass-through

Acknowledgements

The author would like to thank Bill Helkie, Steve Kamin, and Jaime Marquez for helpful comments. The views expressed here are the author's own and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System.

Notes

¹This literature is not to be confused with a larger body of literature that explores the relationships between exchange rates and export or import prices. See Goldberg & Knetter (1997) for a survey of the trade price literature.

²Gross value added equals net value added plus depreciation of fixed capital. The accounts do not show depreciation by sector. For documentation, see the UK Office of National Statistics, The Blue Book 2004.

³A further complication is that the exchange rate might affect PRX and PIM by different proportions, but I show later that these effects are reasonably similar in practice.

⁴This assumption is consistent with the empirical results of Meese & Rogoff (1983) that exchange rates appear to be exogenous with respect to macroeconomic fundamentals. The standard explanation is that unobserved investor preferences and expectations about future macro policies are the main driver of exchange rates and that feedback from sectoral prices and quantities is both weak and slow. This assumption is plausible for the United Kingdom in the 1990s, when exchange rate movements were driven largely by actual and expected macroeconomic policies in the United Kingdom and its major trading partners. In particular, the depreciation of 1992 reflected the adoption of easier monetary policy and the abandonment of the fixed exchange rate. The appreciation of 1996 reflected a tighter fiscal and looser monetary policy in the rest of Europe during the runup to monetary unification.

⁵I focus on the 1990s because of the pronounced exchange rate movements and because the sectoral data of the following section are available only from 1989 through 2002.

⁶RPIX is the retail price index excluding mortgage interest; the RPIX inflation rate was the target variable for monetary policy over most of this sample. PFOR is calculated from the IMF's real effective exchange rate index based on consumer prices (REC) and RPIX using the formula PFOR = RPIX/REC. RPIX was obtained from the UK Office of National Statistics website, www.statistics.gov.uk. REC was obtained from the IMF IFS database.

⁷All national accounts data are available from the Office of National Statistics website, www.statistics.gov.uk.

⁸See, for example, Appendix A in Hooper et al. (2000).

⁹These specifications resulted from a general-to-specific procedure. The initial specification included a lagged dependent variable and three lags of the independent variables. Sequential testing showed that only the first and second lag of the independent variables were significant at the 10% level. LM tests for first-order and second-order serial correlation were not significant at the 10% level.

¹⁰These estimates imply that UK exporters pass-through 60% of exchange rate movements to their export prices and that foreign exporters to the United Kingdom pass-through more than 50%. These pass-through estimates are within the range surveyed by Goldberg & Knetter (1997).

¹¹Lagged responses to exchange rates are commonly found to be greater in trade quantities than trade prices. See, for example, Helkie & Hooper (1988).

¹²There are 11 sectors in all: agriculture, mining, manufacturing, utilities, construction, distribution, transport, finance, public administration, health and education, and other services.

¹³The distribution sector includes wholesale and retail trade, hotels, and restaurants. I would have preferred to focus on wholesale and retail trade, but detailed data were not available at that level of disaggregation. Value added in wholesale and retail trade is roughly four times value added in hotels and restaurants.

¹⁴These and subsequent equations were estimated by a general-to-specific procedure. The initial specification included a lagged dependent variable and three lags of the independent variables. Sequential tests were conducted and terms that were not significant at the 10% level were excluded (unless a higher lag proved significant) and the equation re-estimated. LM tests for first-order and second-order serial correlation were not significant at the 10% level for any equation. Data were obtained from www.statistics.gov.uk.

¹⁵I ignore indirect taxes as they are very small.

¹⁶The three lags of foreign relative prices in the manufacturing sector all had nearly the same coefficient. To conserve degrees of freedom, I restricted the coefficients to be equal.