RDP 9407: Explaining Import Price Inflation: A Recent History of Second Stage Pass-through 1. Introduction

A recent puzzle to emerge in the analysis of inflation in Australia, and indeed elsewhere, is the failure of changes in import prices to alter inflation outcomes despite significant exchange rate movements and increases in import penetration. Following an episode of substantial currency depreciation in the early 1990s, there has been only a small increase in the contribution of retail import prices to inflation. And yet, pass-through of exchange rate changes to import prices recorded over the docks is completed quite rapidly.[1] Given that such “first stage pass-through” is rapid, the lack of inflationary pressure invites an examination of the next stage of price adjustment as imports are distributed to local markets. The responsiveness of the retail import price to changes in the import price over the docks is described here as “second stage pass-through”. Understanding this stage of price adjustment is important when assessing the direct inflationary pressures that accompany exchange rate movements.[2]

The main purpose of this paper is to explore the dynamics of adjustment of retail import prices to changes in the exchange rate. This requires estimation of both first and second stage pass-through. Consequently, an attempt will be made to estimate pass-through from the exchange rate to the price of consumption imports over the docks and, in turn, from these prices to those at the retail level. Particular attention will be paid to differences in both the extent and timing of these price adjustments at each stage. Possible reasons for observed differences in pricing behaviour at the second stage will be discussed.

The retail import is, in effect, a different good to that which lands at the dock. In the process of distribution and sale, value added is contributed by the non-traded goods sector. In consequence, its price should not be expected to move by the same proportion as the price of the imported component, but by a proportion equal to the share of the imported component in total unit costs. In other words, what constitutes complete pass-through at the second stage entails a proportional change in the retail import price that is less than that in the price of the import over the docks.

The paper is organised as follows. In Section 2, recent trends in exchange rates and import prices are discussed. In Section 3, a simple analytical framework is presented which forms the basis of estimation. In Section 4, features of the data required for estimation are discussed. Estimation and results are presented in Sections 5 and 6. In Section 7 the implications of the results are discussed and, finally, conclusions are drawn.


See Phillips (1988) and, for a more recent example, Dwyer, Kent and Pease (1993). [1]

Currency depreciation also has an indirect effect on inflation (via the cost of imported inputs, inflationary expectations and their attendant pressure on wages). These indirect effects may be substantial but are not addressed in the present paper. For an investigation of the full impact of import price changes on inflation see de Brouwer, Ericsson and Flood (1994). [2]