Exchange rate pass-through in a small open economy: the Anglo-Irish case

Abstract

Bilateral import unit values are constructed to investigate the extent and speed of exchange rate and production cost pass-through into the unit values of Irish imports (total and sectoral) from the UK using Menon's (1996) mark-up model. The approach used to measure exchange rate pass-through is based on cointegration and error-correction modelling and the period of analysis is from 1979 to 1995. Full pass-through from the bilateral Irish pound–Sterling exchange rate and from UK producer costs could not be rejected for total and sectoral import unit values for the sample period 1979q1–1995q4. This implies no role for domestic competing prices in explaining the long-run relationship determining unit values of Irish imports from the UK. The results indicate that for aggregate and sectoral unit values of Irish imports from the UK pass-through is incomplete in the short-run.

Acknowledgements

The author is grateful for helpful comments and discussions with Peter Sinclair and Nicholas Horsewood at the University of Birmingham and with colleagues at University College Cork. Any errors are the sole responsibility of the author.

Notes

¹ The pricing to market approach (PTM) stems originally from research by Krugman (1987) and Dornbusch (1987) and refers to exchange rate induced price discrimination in international markets, such as in the case of cars. PTM research includes the microeconomic foundations of exchange rate pass-through (e.g. Feenstra, 1989, Feenstra et al., 1996).

² Further research could focus on the behaviour of prices at different stages of production and how mark-ups vary over the business cycle as considered by Domowitz et al. (1988) and Clark (1996).

³ The determinants of declining inflation from 1982 onwards are difficult to identify as they may be attributable to EMS membership, reduced UK inflation (and world inflation) or the Irish fiscal contraction of the early 1980s that depressed domestic demand (Honohan, 1989, 1993).

⁴ See United Nations (1986) and (1994) for descriptions of the SITC.

⁵ Discontinued series were also provided by the NSO, for which the author is grateful.

⁶ e.g. 56219 denotes mineral or chemical fertilizers, nitrogenous, n.e.s., SITC 5 denotes Chemicals.

⁷ Information on the UK SIC 1990 are available from the NSO, 1996.

⁸ Similar data for the domestic competing price is available from the by the Irish Central Statistics Office, Statistical Bulletin. These data are classified according the European NACE nomenclature of manufacturing industries (European Communities, 1990).

⁹ The problem of noncomparability across trade and industrial activity data is currently being addressed with the latest revisions of industrial classifications. The ISIC rev. 3, for example, is comparable with the NACE rev. 1 and UK SIC 1990 classifications; unfortunately, the ISIC rev. 3 differs significantly from ISIC rev. 2 and cannot be used for this study.

¹⁰ The author is grateful for assistance in supplying these data from Michele Mannato at the OECD.

¹¹ For larger economies it may be plausible that the domestic exchange rate could affect the foreign cost structure. Such a hypothesis is not appropriate here.

¹² Kenny and McGettigan (1998) pointed this out that given the similarity between import and domestic output prices they considered it appropriate to estimate two cointegrating relationships. Import and domestic prices used here, however, do not exhibit strong correlation.

¹³ The coefficient is −0.21 and based on the fact that (1 − 0.21) ⁿ = 0.5 where n represents the number of periods in the half life of deviations of PM from its equilibrium, the half life can be computed by taking natural logs and rearranging to get n = (ln 0.5/ln 0.79) = 2.94 quarters.

¹⁴ No attempt has been made to use a Green Pound exchange rate to consider its effects. This may be a more appropriate exchange rate to consider for this sector.

¹⁵ This figure is the sum of 11.7%, 1.3% and 0.7% – the shares of three sectors’ imports in total Irish imports from the UK, namely, Food and live animals (SITC 0), Beverages and tobacco (SITC 1) and Animal and vegetable oils, fats and waxes (SITC 4).

¹⁶ Since none of the explanatory variables, apart from UK producer costs, enter into the equation for Section 32, it is possible that the coefficient is also including the effects of omitted variables and, hence, should be interpreted with care.