RDP 9407: Explaining Import Price Inflation: A Recent History of Second Stage Pass-through 8. Summary and Conclusions

In Australia's contemporary history, episodes of currency depreciation have tended to be accompanied by an increase in inflation (Stevens 1992). Consequently, strong expectations were formed that the depreciation of the early 1990s would generate inflationary pressures. The “missing” import price inflation has invited an examination of exchange rate pass-through. Most investigations of exchange rate pass-through have focussed on the transmission of the exchange rate to import prices over the docks. However, it is the retail price of an import, and not that over the docks, that directly enters measured inflation. Thus understanding the second stage of price adjustment as imports are distributed to local markets is central to any assessment of the inflationary consequences of currency depreciation.

This paper has measured exchange rate pass-through at both the first and second stage. It has shown that changes in the exchange rate are quickly transmitted to the prices of consumption imports over the docks. First stage pass-through is fast and unambiguously complete. Second stage pass-through is also complete but, because of the existence of domestic costs, the retail import price does not move by the same proportion as the over-the-docks price, even in the long run. Furthermore, the adjustment process is very slow.

In popular discussion of second stage pass-through, when movements in retail import prices are observed to fluctuate by less than those over the docks, there has been a tendency to interpret these movements as incomplete pass-through. However, if the long-run elasticities represent cost shares, the elasticity of the retail import price with respect to that over the docks cannot be unity. It must instead reflect the value of the import as a share of total costs, and so be less than unity. Consequently, complete pass-through at the second stage entails less than proportional movement. The second stage results accord with this notion and suggest that the share of the landed import price in total costs is about 66 per cent.

In the short run, however, adjustment is slow and the rate of pass-through is clearly much less than this cost share would imply. Thus, by any standards, second stage pass-through is incomplete for sustained periods. This occurs because importers' mark-ups are varied to insulate consumers from changes in the cost of the import, such as result from exchange rate fluctuations. In fact, persistent variations in importers' mark-ups lead to slow adjustment at the second stage, thereby dissipating the inflationary consequences of currency depreciation.