Implications of production sharing on exchange rate pass-through

INTERNATIONAL JOURNAL OF FINANCE & ECONOMICS

Int. J. Fin. Econ. 14: 334–345 (2009)

Published online 25 July 2008 in Wiley InterScience

(www.interscience.wiley.com). DOI: 10.1002/ijfe.374

IMPLICATIONS OF PRODUCTION SHARING ON EXCHANGERATE PASS-THROUGH

AMIT GHOSH�,y

Department of Economics, Illinois Wesleyan University, USA

ABSTRACT

This paper presents a theoretical model to analyse exchange rate pass-through when there is cross-border productionsharing. With production sharing, between two nations, we have pass-through at two different levels, one at the level ofthe imported parts and components used in making the final good and the other at the level of the final good. We findthe higher the pricing-to-market at the intermediate good level, the lower the pass-through for the final good. Themodel is further extended to analyse three-country production sharing, substitution between two alternate sources ofimported inputs. Finally, we draw some policy implications. Copyright r 2008 John Wiley & Sons, Ltd.

JEL CODE: F15; F41

KEY WORDS: Production sharing; exchange rate pass-through; pricing-to-market; inflation

NON-TECHNICAL SUMMARY

Production sharing or international fragmentation refers to the dispersion of separate production blocks ofan integrated production process across different countries. As such it gives rise to trade in final goods aswell as parts and components, required to produce the former among trading nations. Over the last onedecade production sharing trade has expanded at a faster rate than growth of world trade and world grossdomestic product. This paper presents a theoretical model to analyse the impact of the process offragmentation on exchange rate pass-through (ERPT). Pass-through may be defined as the percent changein import prices in the importing nation’s currency due to 1% change in the exchange rate between the twotrading nations. A term related to pass-through is the concept of pricing–to-market (PTM)—the percentchange in export prices in the exporters’ currency due to the exchange rate change. With productionfragmentation, in the context of a two-commodity framework, we have ERPT at two different levels, one atthe level of the imported parts and components used in making the final good and the other at the level ofthe final good. We start by assuming that the exporting nation imports its input from its trading partnerand then in another form of production sharing from a third nation. Initially our framework is static byassuming full pass-through for the intermediate good that is imported. Then we move to a dynamicframework by modelling the pricing behaviour of exporters of the parts and components; i.e. we allow forincomplete pass-through at the intermediate good level. In both forms of production sharing, ERPT intothe final good becomes lower following the exporting nation’s currency depreciation against the other twonations, compared with the situation of standard trade. Our results show that the higher the PTM at thecomponents level, the lower the ERPT for the final good. Finally, the model also considers the possibility of

*Correspondence to: Amit Ghosh, Department of Economics, Illinois Wesleyan University, Bloomington, IL 61701, USA.yE-mail: [email protected]

Copyright r 2008 John Wiley & Sons, Ltd.

switching between a domestic and intermediate input and also between two alternate sources of importedinputs. Recent literature on pass-through has focused on not only low but declining pass-through aroundthe world. One of the underlying factors behind this, though relatively under-researched, is the increasingdispersion of production processes across different nations.

1. INTRODUCTION

This paper examines the transmission of exchange rate changes into export (import) prices when there iscross-border production sharing—division of an integrated production process into different locations,across different countries. When nations are engaged in production sharing, they become integrated withone another in the production process of the commodity. With international fragmentation or productionsharing, final goods as well as parts and components, required to produce the former, are traded betweennations.1 The paper presents a theoretical model where we consider the extent of pass-through for not onlyat the final goods level, but also at the level of the intermediate goods and the impact of the later on theformer. Initially, our framework is static in the sense we assume full pass-through for the intermediate goodthat is imported. Then we move to a dynamic framework by modelling the pricing behaviour of exporters ofthe intermediate good; i.e. we allow for incomplete pass-through at the intermediate good level.

The simplest form of production sharing is involving two nations trading both final goods as well as theircomponents. The other form of production sharing involves three nations, where one nation imports thecomponents from another and then uses it to produce and export the final good to a third nation. In eitherof production sharing, we see that exchange rate pass-through (ERPT) becomes lower following theexporting nation’s currency depreciation against the other two nations, compared with the situation ofstandard trade. However, when its currency depreciates against one nation and appreciates against theother, we get a higher rate of pass-through. Our results show that the higher the pricing-to-market (PTM)at the intermediate good level, the lower the pass-through at the final good level and vice versa. The paperalso considers the possibility of switching between two alternate sources of imported inputs. From a policyperspective, lower pass-through due to production sharing would make exchange rate-based adjustmentsless effective in improving a nation’s trade balance.

Pass-through is defined as the percentage change in local currency import prices resulting from a 1%change in the exchange rate between the exporting and importing nations. A term related to pass-through isthe concept of PTM, which refers to the link between exchange rate and export prices, in terms of homecurrency of exporter (Knetter, 1993). PTM is the practice of limiting the pass-through of exchange ratechanges to the importing nation’s currency prices of the exports by adjusting profit margin of exporters.2

On one extreme, if exporters are completely unresponsive to exchange rate fluctuations, then exchange ratechanges are fully passed to the buyer’s currency. (i.e. there is no price-to-market). On the other, if exporters’currency denominated prices of the good are changed by exactly the same magnitude of the exchange ratechange but in the opposite direction, then exchange rate changes are fully absorbed in the prices of theexporters and there is zero pass-through or full price-to-market. In the intermittent case if the exporters’currency denominated currency price is changed partially following the exchange rate change, we haveincomplete pass-through.

There is a vast body of literature that has explained the determinants of the degree of pass-through intotrade prices. It depends on a number of factors like the nature of the goods or industries looked at, theelasticity of demand in the export market (i.e. the degree of market power of the exporting nation), thedirection, duration and magnitude of exchange rate changes.3 While these above factors are important inanalysing the extent of pass-through, in this paper we look at ERPT from another perspective—in thecontext of cross-border production sharing.

Aksoy and Riyanto (2000) consider two vertically integrated markets, one for final goods and the otherfor intermediate goods. In their theoretical model, if there is vertically separated production then the firmproducing the final good imports its intermediate good. While if there is vertical integration, thedownstream firm obtains the input from its own upstream input supplier at the internal transfer price. It is

IMPLICATIONS OF PRODUCTION SHARING 335

Copyright r 2008 John Wiley & Sons, Ltd. Int. J. Fin. Econ. 14: 334–345 (2009)

DOI: 10.1002/ijfe

shown that pass-through is lower in the former case. Hegji (2003) builds a theoretical model where a parentfirm exports an intermediate good to its foreign affiliate. The latter imparts value-added on the intermediategood and sells in the foreign market. The model shows that with intra-firm trade pass-through is less thancomplete. In terms of the model, pass-through can be complete if either the foreign affiliate does not imputeany value-added or if the price elasticity of demand for the intermediate good in the foreign market fromthe parent firm is completely insensitive to prices. This branch of literature emphasizes the role ofmultinational companies (MNCs) operating in more than one nation.

While MNCs and the consequent intra-firm trade between the headquarter and its foreignaffiliate play an important role in production sharing, presently fragmentation has expanded beyond thedomain of MNCs. Fragmentation provides opportunities for firms in developing economies to be involvedin arms length transactions with developed countries by specializing in just one part of theproduction process. We present a model where a firm imports (exports) parts and components fromanother nation, uses it produce a final good, which it then uses to export (import) either to that same nationor to a third country.

With production sharing the role of imported inputs in affecting pass-through becomes important.Existing literature suggests that pass-through is muted when firms use imported inputs.4 Webber (1995)considers the role of pass-through when firms use imported inputs and shows that pass-through isincomplete or partial when their imports are procured from another country and invoiced in a thirdnation’s currency. This explains the low pass-through of 10% that the author finds for Japanese exports oftransport equipments to Australia, which were made of parts imported from Australia and denominated inthe US dollar. With imported inputs used in producing an export good, an exchange rate change can beperceived as cost shocks.5 Yang (1997, 1998) shows that there is a negative relationship between theelasticity of marginal cost (MC) with respect to exchange rate change and pass-through. The greater theelasticity of MC with respect to exchange rate, the more will be the change in MC following the currencychange. This offsets the effect of the exchange rate change on the foreign firm’s price in the importingnation’s currency leading to lower pass-through.

The paper is organized as follows. Section 2 introduces the theoretical model, which comparesthe extent of pass-through when there is standard trade with that of fragmentation-based trade. Wesee that pass-through is lower for the latter type of trade. Initially we consider two-country cross-borderproduction sharing—a representative firm B of country B exporting a final good Y to its tradingpartner A similar to Ghosh and Rajan (2007). Section 2.3 further extends the analytical set-up bymodeling the level of pass-through at the intermediate goods level by modelling the pricing behaviour of arepresentative firm in A exporting the intermediate good or components X, and the implications of thison the pricing behaviour of firm B, which uses X in producing and exporting final good Y. In Section 3 weconsider fragmentation involving three nations, where country B imports it intermediate good Xfrom a third nation C, using it to produce and export the final good to A. Finally, in Section 4 we drawsome policy implications from the results of our theoretical model.

2. THEORETICAL MODEL

2.1. Pass-through with standard trade

We consider a representative firm B (in country B) producing a good Y using both domestic labour anddomestically made parts and components (PCAs) X. Firm B is an imperfect competitor and sets the price ofits export good in its own currency. We assume that firm B has some market power in the sense that byvarying its price in its own currency it can affect the A currency price of Y.6 This is the situation of standardtrade. In Section 2.2, we consider the case where firm B imports X from partner nation A, uses it producethe final good Y using its domestic labour and exports it back to A. We assume B to be a labour abundantnation with a perfectly elastic labour supply, such that any increase in labour demand can be met at thegiven wage rate. Let the cost of input X be denoted by PB

X . This is in firm B’s currency. The production

A. GHOSH336


DOI: 10.1002/ijfe

function for good Y is of Cobb–Douglas form:

Y ¼ aLaXb ð1Þ

where a is a constant and both a, bA(0,1) and a1b5 1.The demand function for firm B is given as

Y ¼ bðPY Þ�1=s ð2Þ

where s is a constant and the inverse of the elasticity of demand and sA(0,1). The inverse demand functionfor good Y is

PY ¼ cY�s where c ¼1

b

� ��sThe profit function of firm B denominated in its own currency is given by

p ¼ PYY � wBL� PBXX ð3Þ

MaxL;X¼ ca1�sLað1�sÞXbð1�sÞ � wBL� PB

XX

dpdL) lLað1�sÞ�1Xbð1�sÞ � wB ¼ 0

dpdX) mLað1�sÞXbð1�sÞ�1 � PB

X ¼ 0 where l ¼ cað1�sÞað1� sÞ;m ¼ cað1�sÞbð1� sÞ

We follow the same sequence of substitution in deriving the pass-through expression as in Webber (1995).From the two first-order conditions, taking logarithm and re-arranging we get the expression for Labour Land good X demand. Detailed description of the derivations is available upon request from the author:

lnL� ¼Afbð1� sÞ � 1g

½½bð1� sÞ � 1� fð1� sÞa��

fðlnPBX � ln mÞ

½bð1� sÞ � 1� fð1� sÞa�ð4Þ

lnX� ¼ lnPBX

½1�½bð1� sÞ � 1� fð1� sÞa�

� ln m½1�

½bð1� sÞ � 1� fð1� sÞa�� u ð5Þ

where

A ¼ðlnwB � ln lÞað1� sÞ � 1

f ¼ð1� sÞa

bð1� sÞ � 1

and

u ¼b ln m

bð1� s� 1� fð1� sÞa

Now taking logarithm of the production function (1) we have

lnY ¼ ln aþ a lnL � þb lnX�

lnY ¼ lnPBX

½b� af�½bð1� sÞ � 1� fð1� sÞa�

þ V ð6Þ

where V is a sum of constants.



DOI: 10.1002/ijfe

Using the logarithm of the inverse demand function and substituting (6) in it gives us

lnPBY ¼ ln c� s lnY

¼ ln c� s lnPBX


� sVð7Þ

Let EAB be A’s currency per unit of B’s currency. Now the price of Y in country A is given by PA

Y ¼ EABP

BY .

In log form we have

lnPAY ¼ lnEA

B þ lnPBY ð8Þ

Taking total derivative of (8) we get the expression for ERPT:

d lnPAY

d lnEAB

¼d lnEA

B

d lnEAB

þd lnPB

Y

d lnEAB

ERPT ¼ 1� sd lnPB

X

d lnEAB


� �ð9Þ

The ERPT expression shows that if the currency change has no impact on price of domestic input X thend lnPB

X=d lnEAB ¼ 0 and we can have complete pass-through. However, if the increased demand for X, due

to depreciation of country B’s currency, raises the price of X, it further increases costs for firm B. Given thata, b, sA(0,1) this implies that �1ofo0 and �1o½b� af�=½bð1� sÞ � 1� fð1� sÞa�o0.

The second term is now negative (see Appendix A) and pass-through is incomplete.

2.2. Two-Country production sharing and pass-through

Now we introduce production sharing. We assume that production in the two economies is organized intwo tiers—at the intermediate good level in country A, where domestic labour (and may be other naturalresources) is used to produce good X, and an upper tier, where production takes place in country B, whichcombines components X from A and domestic labour to produce final good Y.7 Country B now imports thecomponents X from country A, which is more efficient in producing good X. The price of intermediate goodPAX now is in A’s currency which B takes as given. The profit function for firm B is

p ¼ PYY � wBL�PAX

EAB

X ð10Þ

Following the same procedure we arrive at the following equations:

lnY ¼ ðlnPAX � lnEA

B Þ½b� af�

½bð1� sÞ � 1� fð1� sÞa�þ V ð11Þ

lnPBY ¼ ln c� s lnPA

X


þ s lnEAB


� sV ð12Þ

The ERPT d lnPAY=d lnEA

B is given by

ERPT ¼ 1� sd lnPA

X

d lnEAB


� �þ s


ð13Þ

Here the expression d lnPAX=d lnEA

B shows the PTM by exporters of X in A at the input level. If we assumethat exporters of X in country A keep their currency price of X unchanged following B’s currencydepreciation, i.e. we have no PTM at the input level, then d lnPA

X=d lnEAB ¼ 0. Equation (13) is less than

unity as the third term is negative A(�1,0). So fragmentation of the production process leads to lower pass-through. The intuition is, say, with an appreciation of country A’s currency, its imports of Y becomecheaper raising demand for it. But A’s currency appreciation increases B’s currency price of import X. Thismeans more production costs, causing firm B to raise the price.8 The price of Y in the destination market is

A. GHOSH338


DOI: 10.1002/ijfe

the balance of two forces—the downward movement of the exchange rate EAB and the upward movement in

B’s currency price of Y, PBY . With fragmentation the changes or variations in costs following a currency

change is more, than without production sharing, causing firms to change their currency price of exports bya greater extent (i.e. practise more PTM). Thus ERPT is lower. Figure 1 shows the two-countryfragmentation case below.

Starting from the initial equilibrium point a0, where marginal revenue (MR) intersects MC, withstandard trade, A’s currency appreciation increases the MCs of firm B. This is shown by the shift of thecurve to MC0Y no ps with the new equilibrium at a1. The new price of Y in B’s currency is P0Y no ps. Now withfragmentation, the usage of imported input X shifts out the MC curve even further to MC0Y ps. Theequilibrium is at a2 and the price of Y rises even more to P0Y ps. Firm B absorbs more of the exchange ratechange in its own price of Y thereby leading to lower pass-through. The greater the extent of the importedinput used in the production process, the more the change in costs and the lower the ERPT.

2.3. PTM at input level X

Unto now our analysis has been static in the sense we have not modelled the pricing behaviour ofexporters of components X in country A. Next we look into their pricing decisions. Similar to that of firm B,the production function, the demand function and the profit functions of X producers in A are as follows:

X ¼ dLyA ð14Þ

where 0oyo1,

X ¼ eðPAX Þ�1=g or PA

X ¼ fX�g ð15Þ

where 0ogo1 and f ¼ ð1=eÞ�g;

pA ¼ PAXX � wALA ð16Þ

where wA is the wage rate in X sector in A.Using the same procedure9 as for firm B, we obtain the optimal demand function for input LA and plug

that into the production function (in log form). Substituting this into the inverse demand function we arriveat the expression for PTM for input X:

d lnPAX

d lnEAB

¼ �gy

½yð�gþ 1Þ � 1�d lnwA

d lnEAB

ð17Þ

We have no PTM when d lnPAX=d lnEA

B ¼ 0 i.e. if d lnwA=d lnEAB ¼ 0.

Figure 1. Two-country fragmentation—A’s currency appreciates with B.



DOI: 10.1002/ijfe

Next we relax this assumption of no PTM by exporters of X in A and see its implications. In the situationof standard trade, with an appreciation of the exporting nation’s currency, exporters generally reduce theircurrency price of exports, as they try to maintain destination currency stability of prices and not losemarket share. But with production fragmentation, an appreciation of A’s currency here raises its imports offinal good Y. This in turn raises the demand for A’s exports of the intermediate good. If this puts upwardpressure on wages in sector A, then firm A will raise PA

X instead of reducing it as in the standard tradecase.10 This implies that d lnwA=d lnEA

Bo0 and hence d lnPAX=d lnEA

Bo0. For firm B this leads to evenhigher costs and from equation (13) ERPT is lower for final good Y. The higher the PTM at the level ofcomponents good X, the lower is ERPT at the final goods level.

3. FRAGMENTATION AND PASS-THROUGH INVOLVING THREE NATIONS

Here we introduce the other form of production sharing involving three nations—firm B exports to A, butprocures it intermediate good X from a third nation C.11 Now we have another exchange rate—between Band C. Let EB

C denote B’s currency per unit of C’s currency. Also let PCX be the price of X in C’s currency. So

the price of X in B’s currency is EBCP

CX . Firm B’s profit function is given by

p ¼ PYY � wBL� EBCP

CXX ð18Þ

ERPT for final good Y in A is given by

ERPT ¼ 1� sd lnPC

X

d lnEAB


� �� s


d lnEBC

d lnEAB

¼ 1�d lnPC

X

d lnEBC

d lnEBC

d lnEAB

� �s


� �� s


d lnEBC

d lnEAB

ð19Þ

If country B’s currency depreciates against both nations and assuming for simplicity by the samemagnitude, then the situation boils down to the earlier situation of two-country production sharing. Alsoanalogous to the earlier situation if the rise in demand for Y causes producers of X in C to raise their prices,pass-through into price of Y in A will again be even lower as compared with no PTM at the level of input X.Section 3.1 considers the scenario when B’s currency depreciates against one but appreciates against theother.

3.1. Country B’s currency depreciates against A and appreciates against C

We again assume that the extent of change in both currencies is the same (d lnEBC=d lnEA

B ¼ 1).12

Following (19) the ERPT expression is given by

ERPT ¼ 1� sd lnPC

X

d lnEBC


� �� s


ð20Þ

With no PTM for good X, the cheaper imported inputs moderate production costs increasing supply andreducing B’s currency price of Y. This amplifies the decline in EA

B causing more pass-through as seen fromequation (20). Figure 2 shows this.

The depreciation of B’s currency raises the demand for A’s exports thereby shifting out both the demandand MR curve. But now its stronger currency with respect to C has a ‘cushioning’ effect on MCs shiftingout the MC curve to a lesser extent to MC0ps with the new equilibrium at b2. This leads to a less rise in itsown currency denominated price of B (to P0BY ps) and hence more pass-through into country A’s importprice of final good Y.

The appreciation of B’s currency makes imported inputs cheaper raising the demand for X from C.Also A’s currency appreciation raises the demand for final good Y, which in turn further raises the

A. GHOSH340


DOI: 10.1002/ijfe

demand for input X by B from C. These two forces move in the same direction raising the demand of C’sexports. If this puts upward pressure on costs of C in terms of higher wages in C, then d lnwC=d lnEB

Co0implying higher PX

C . Now we have a lower pass-through for final good Y (the second term in equation (20)is positive) as compared with the situation considered earlier of no PTM at the input level. This is sobecause the cost reduction that firm B gains from its currency appreciation with C is partly nullified by therise in price of X by producers in C. This leads to higher production costs and hence lowers pass-through atthe level of the final good Y, than with no PTM for good X.

3.2. Substitution between two sources of imported inputs

We have looked at the possibilities of a firm sourcing its input either domestically or from a foreignsource. Here, we consider a situation where firm B has the option of procuring its input X from twoalternate foreign sources—from either country A or from country C.13 In such a situation, the compositeinput X0 takes the form

X 0 ¼ ½d½ðXAÞ�r�1=r þ ð1� dÞ½ðXCÞ�r�1=r�r�1=r

and the composite price index for X is captured by the following constant elasticity of substitution (CES)form14:

P0X ¼ dPAX

EAB

� �� 1�rþð1� dÞ½ðPC

X Þ�1�r�1=1�r

"ð21Þ

where r41 measures the degree of substitution between the input XA and XC.With the possibility of using a combination of the alternate sources of inputs, the firm’s profit function is

given by

p ¼ PYY � wBL� E 0P0XX0 ð22Þ

where E0 is the X-industry trade weighted nominal effective exchange rate of country B:

E0 ¼XA

XA þ XC

� �1

EAB

� �þ

XC

XA þ XC

� �ðEB

CÞ� �

ð23Þ

with tA ¼ XA=ðXA þ XCÞ and tB ¼ XB=ðXA þ XCÞ being the trade shares.

Figure 2. Three-country production sharing—B’s currency depreciates with A but appreciates with C.



DOI: 10.1002/ijfe

Now ERPT is given by

ERPT ¼ 1� sd lnP0Xd lnEA

B


� �� s


d lnE0

d lnEAB

ð24Þ

The degree of substitution between the two imported inputs depends on the relative price differential beforeand after the currency changes. If one input becomes relatively cheaper, following the exchange ratechanges more would be the substitution towards it.15

r ¼ rPAX=E

AB

EBCP

CX

��

before and after exchange rate changes and r0 > 0.In one extreme, if there is complete substitution towards XA such that r ¼ 1 and d ¼ 1, then tA ¼ 1,

implying that X05XA, P0X ¼ PAX and E 0 ¼ 1=EA

B , the profit function boils down to equation (10) and ERPTis given by equation (13), the two-country production sharing case. On the other extreme, if there iscomplete substitution towards XC, then P0X ¼ PC

X and E0 ¼ EBC, the profit function is given by equation (18)

and pass-through by equation (19).From our analysis in Sections 2 and 3, we know that when firm B is using input from either A or C only

and its currency depreciates against either then pass-through is lowest as given by equation (13), with noPTM at the input level X. On the other side, pass-through is highest when firm B uses inputs from C onlyand its currency appreciates with respect to C, as given by equation (20). Given these two corner solutions,with the usage of a combination of two inputs the extent of pass-through as given by equation (24) dependson the expression d lnE0=d lnEA

B:. If only components from A are used then E0 ¼ 1=EAB and

d lnE0=d lnEAB: ¼ �1, and if components from C are used (with B’s currency appreciating with respect

to C) then E0 ¼ EBC and d lnE0=d lnEA

B: ¼ 1. These are the two ranges for d lnE 0=d lnEAB:. When the

combination of two inputs is used, if �1o d lnE0

d lnEAB:o0 then pass-through is more than equation (13) but

lower than equation (20), while if 0o d lnE0

d lnEAB:o1 then also pass-through is more then equation (13) but less

than equation (20), assuming full pass-through at the level of components X. With a combination of twoalternate imported components used pass-through is intermittent—lying between equations (13) and (20).The ability to substitute between the two sources of inputs enables the firm to moderate on costs followingexchange rate changes and thus engage in less PTM and pass-through more of the exchange rate changes inthe destination market of the final good.

4. POLICY IMPLICATIONS

With cross-border production sharing involving two nations, ERPT is lower as compared with the situationof standard trade. The model shows this is regardless of the extent of PTM at the level of the intermediategood X. With lower pass-through, price of Y in the importing nation (A here) would change to a lesserextent before and after the exchange rate change. This implies that trade flows of final goods would be lessresponsive to exchange rate changes. If we consider country B to be Mexico and A the US, then for theMexican economy an implication of engaging in production sharing with the US would be that its tradeflows will be less affected by its currency fluctuations with the US dollar. Low pass-through would alsoimply that any exchange rate-based adjustments in improving the trade balance for these economies may beless effective. To achieve a given change in the trade balance now the burden of adjustment falls on themagnitude of exchange rate change i.e. the change has to be greater when there is fragmentation.

From the perspective of a nation like the US, an appreciation raises its imports of final goods, but at thesame time it raises its exports of components X. This is a result contrary to standard trade where anappreciation reduces a nation’s exports.16 From another view point, for countries like the US that sourceout certain stages of the production process across their borders the low pass-through into final goodsprices result suggests that increasing fragmentation-based trade would help keeping inflation low withintheir domestic economy.

A. GHOSH342


DOI: 10.1002/ijfe

Moreover, using our analytical framework we can see how an exchange rate change feeds throughinflation in B. B’s currency depreciation with respect to A raises price of X in B. It rises even more ifexporters of X engage in some price-to-market for the intermediate good X. If B is a highly open economy,and the extent of production sharing to standard trade is high, then this would creep inflation in B. Forsmall, open economies especially in the Central American, Caribbean region or Asia where fragmentation-based trade is highest, production sharing networks may raise inflationary pressures in their economiesthrough the usage of imported inputs from more technically advanced nations. This inflationary pressurewould be more acute when B enters into production sharing network involving two other nations, A whereit exports the final good and C from where it procures components X and its currency depreciates withrespect to both. However, if B’s currency depreciates against A and appreciates against C, pass-through ismore as seen earlier but inflation in B is also less. This would be the situation when B has a basket-peggedexchange rate with the currencies of A and C. As such, if inflation is a major concern for policy makers in B,then pegging its exchange rate with A’s and C’s currency might be a way of controlling inflation.

ACKNOWLEDGEMENTS

The author acknowledges the helpful suggestions and comments provided by Sven Arndt, Arthur Denzau,Ramkishen Rajan, Slavi Slavov and Thomas Willett. Views expressed are those of the author. The usualdisclaimer remains.

APPENDIX A

Production sharing involving two countries

The ERPT expression equation (9) is

ERPT ¼ 1� sd lnPB

X

d lnEAB


� �

ð1� sÞa40 ðA1Þ

�1obð1� sÞ � 1o0 ðA2Þ

It follows from (A1) and (A2) that since f ¼ ð1� sÞa=bð1� sÞ � 1 it must be that �1ofo0.Given this, we consider the second term of the pass-through expression. The numerator is

b� af40 ðA3Þ

Turning to the denominator,

fð1� sÞao0 ðA4Þ

So

0of�fð1� sÞaþ bð1� sÞgo1 ðA5Þ

i.e. it is positive and lying between 0 and 1.Now consider the entire denominator. The expression is

�1o½f�fð1� sÞaþ bð1� sÞg � 1�o0 ðA6Þ

and lies between 0 and �1.Thus it follows from (A3) and (A6) that the second term in the ERPT expression is negative.



DOI: 10.1002/ijfe

APPENDIX B

Derivation of the expression for PTM and pass-through of components X exported by firm A

Substituting equations (14) and (15) in equation (16) and solving for LA we get

Lyð�gþ1Þ�1A ¼

wA

fd ð�gþ1Þyð�gþ 1Þ

L�A ¼1


� �1=ðyð�gþ1Þ�1ÞðwAÞ1=ðyð�gþ1Þ�1Þ

¼ gðwAÞ1=ðyð�gþ1Þ�1Þ where g ¼1


� �1=ðyð�gþ1Þ�1ÞTaking logs we have

lnL�A ¼ ln gþ1

yð�gþ 1Þ � 1lnwA

Taking logs of production function (14) and substituting lnL�A we get

lnX� ¼ ln d þ y ln gþy

yð�gþ 1Þ � 1lnwA

Now taking logarithm of the inverse demand function (15) and substituting lnX� in it we have

lnPAX ¼ ln f � g ln d � y ln g�

gy½yð�gþ 1Þ � 1�

lnwA

Thus the expression for PTM for firm A is given by

d lnPAX

d lnEAB

¼ �gy


d lnEAB

ðB1Þ

The price of good X in B’s currency is given by

PBX ¼

PAX

EAB

lnPBX ¼ lnPA

X � lnEAB

d lnPBX

d lnEAB

¼d lnPA

X

d lnEAB

�d lnEA

B

d lnEAB

This gives us the expression for ERPT for X:

ERPT ¼d lnPB

X

d lnEAB

¼ �gy


d lnEAB

� 1

If d lnwA=d lnEAB ¼ 0 we have no PTM and ERPT is full for intermediate good X as ERPT5 1.

A. GHOSH344


DOI: 10.1002/ijfe

NOTES

1. For detailed discussions on production sharing see the volume of papers in Arndt and Kierzkowski (2001) and Cheng andKierzkowski (2001).

2. ERPT refers to the pricing behaviour measured in importing nation’s prices and the PTM with the exporting nation’s prices. Inother words PTM implies that firms with market power in a segmented market are able to sell the same product at different pricesin different segments of the market.

3. For detailed analysis on these aspects of ERPT see Knetter (1993), Yang (1997), Pollard and Coughlin (2003), Madhavi (2002),Froot and Klemperer (1989), Krugman (1987) and Ware and Winters (1988).

4. Goldberg and Knetter (1997) states ‘With the use of imported inputs, currency changes will change the costs incurred in procuringthese inputs. Increased foreign outsourcing means an increase in the share of costs incurred in foreign currency. This will bringabout more changes in mark-ups and lesser change in local currency price of imports i.e. lesser pass-through. At a firm level,movements in the value of the home currency against say, the dollar influence the exporting firm’s marginal costs by inducingsubstantial imported input price change. This also makes pass-through (especially to the U.S.) muted relative to other markets’.

5. With the use of inputs price of which is denominated in another nation’s currency, the channel through which exchange ratechanges impact pass-through is costs, which in turn has an effect on the pricing decisions of firms.

6. We consider an imperfectly competitive set-up to capture the effect of the process of fragmentation on pass-through, rather thanassuming that firm B is small and absorbs all cost shocks in its profit margin by adjusting its own currency export price.

7. We can consider production sharing as a North–South trade where North (i.e. A) here is technology rich and specializes in X (say autoparts or parts of computers), while the South B is labour abundant and does the labour-intensive assembly and processing operations.

8. With production sharing, when firms use imported inputs for assembly operations, an exchange rate change enters into its MCfunction, an effect that would be absent without production sharing. This leads to lower pass-through that is apart from any PTMstrategies.

9. For a detailed analysis of the description, see Appendix B.10. This is likely to be the situation if the appreciation is large enough and is also perceived to be permanent. For a detailed discussion

of the extent of pass-through on the duration of exchange rate change, see Froot and Klemperer (1989), Krugman (1987) andPollard and Coughlin (2003).

11. This is production sharing involving three countries, two goods and two exchange rates (EAB and EB

C). This is more relevant forproduction sharing involving Asian countries, where technologically advanced nations like Japan, Taiwan, etc. produce thecapital-intensive components, which are then assembled in lower-wage countries like China, Vietnam or Indonesia and thenexported to the US or Western Europe.

12. An intuitive example here would be the Chinese yuan appreciating vis-a-vis the Japanese yen but depreciating relative to the USdollar by the same magnitude.

13. Countries in a given region like East Asia are interlinked by supply networks, with firms in different regions specializing in similarproducts. This introduces more elements of competition, enabling firms to substitute between alternate sources of inputs.

14. With usage of two alternate sources of inputs, such a similar form has been used by Yang (1997) and Swenson (2005).15. If B’s currency depreciates against both the currencies, both become expensive. Firm B will use more of that input that becomes

relatively cheaper. If A’s currency depreciates against one and appreciates against another, then substitution will be most—towardsthe one that has now become relatively cheaper.

16. Also the dollar appreciation leads to more production in sector X, thereby rising employment in X industry. This contradicts theview that fragmentation or outsourcing would lead to job losses within a nation like the US. Although the purpose of this analysisis not to show the employment effects of fragmentation, our model shows that jobs may be reduced in one sector butsimultaneously created in another sector within the same industry. Instead of an exogenous change in the exchange rate, theemployment effect can similarly be shown by an exogenous change in demand for the good Y.

REFERENCES

Aksoy Y, Riyanto Y. 2000 Exchange rate pass-through in vertically related markets. Review of International Economics 8: 235–251.Arndt SW, Kierzkowski H (eds). 2001. Fragmentation: New Production Patterns in the World Economy. Oxford University Press:

New York.Cheng L, Kierzkowski H (eds). 2001. Production and Trade in East Asia. Kluwer Academic Publishers: Boston.Froot KA, Klemperer PD. 1989. Exchange rate pass-through when market share matters. The American Economic Review 79: 637–654.Ghosh A, Rajan RS. 2007. A survey of exchange rate pass-through in Asia. Asian-Pacific Economic Literature 21: 13–28.Goldberg PK, Knetter M. 1997. Goods prices and exchange rates: what have we learned? Journal of Economic Literature 35:

1243–1272.Hegji CE. 2003. A note on transfer prices and exchange rate pass-through. Journal of Economics and Finance 27: 396–403.Knetter MM. 1993. International comparisons of pricing-to-market behavior. The American Economic Review 83: 473–486.Krugman P. 1987. Pricing to market when the exchange rate changes. In Real Financial Linkages Among Open Economies, Arndt SW,

Richardson JD (eds). MIT Press: Cambridge, MA.Madhavi S. 2002. The response of the US export prices to changes in the dollar’s effective exchange rate: further evidence from

industry level data. Applied Economics 34: 2115–2125.Pollard PS, Coughlin CC. 2003. Size matters: asymmetric exchange rate pass-through at the industry level. Federal Reserve Bank of St.

Louis Working Paper 2003-029B.Swenson D. 2005. Overseas assembly and country sourcing choices. Journal of International Economics 66: 107–130.Ware R, Winter RA. 1988. Forward markets, currency options and the hedging of foreign exchange risk. Journal of International

Economics 25: 291–302.Webber A. 1995. Partial small country import pass-through, currency composition and imported inputs. International Economic

Journal 9: 13–29.Yang J. 1997. Exchange rate pass-through in U.S. manufacturing industries. The Review of Economics and Statistics 79: 95–104.Yang J. 1998. Pricing-to-market in U.S. imports and exports: a time series and cross-sectional study. The Quarterly Review of

Economics and Finance 38: 843–861.



DOI: 10.1002/ijfe

Implications of production sharing on exchange rate pass-through

Documents

Transcript of Implications of production sharing on exchange rate pass-through