Who Bears the Cost of a Change in the Exchange Rate?

Abstract

Nominal exchange rates are remarkably volatile. They ordinarily appear disconnected from the fundamentals of the economies whose currencies they price. These facts make up a classic puzzle about the international economy. If prices do not respond fully to changes in the nominal exchange rate, who bears the cost of such large and unpredictable changes: foreign firms, domestic firms, or domestic consumers? This study develops a structural approach to analyze the welfare effects of a change in the nominal exchange rate using the example of the beer market. I estimate a structural econometric model that makes it possible to compute manufacturers’ and retailers’ pass-through of a nominal exchange-rate change without observing wholesale prices or firms’ marginal costs. I conduct counterfactual experiments to quantify how the change affects domestic and foreign firms’ profits and domestic consumer welfare. The counterfactual experiments show that foreign manufacturers bear more of the cost of a change in the nominal exchange rate than do domestic consumers, domestic manufacturers, or the domestic retailer. Following a 10-percent domesticcurrency depreciation, foreign manufacturers’ profits decline by 22 percent, domestic consumer surplus falls by 8 percent, the retailer’s profits fall by 5 percent, and domestic manufacturers’ profits increase by 1.7 percent. The model can be applied to other industries and can serve as a tool to assess the welfare effects of various exchange-rate policiesexchange-rate pass-through: cross-border vertical contracts