A framework for identifying the sources of local currency price stability with an empirical application

The inertia of traded goods' local currency prices in the face of exchange rate changes is a well-documented phenomenon in the field of international economics. This paper develops a framework for identifying the sources of local currency price stability. The empirical approach exploits manufacturers' and retailers' first-order conditions, in conjunction with detailed information on the frequency of price adjustments in response to exchange rate changes, to quantify the relative importance of fixed costs of repricing, local-cost nontraded components, and markup adjustment by manufacturers and retailers in the incomplete transmission of exchange rate changes to prices. The approach is applied to micro data from the beer market. We find that (a) wholesale prices appear more rigid than retail prices; (b) price adjustment costs on average account for up to 0.5 percent of revenue at the wholesale level but only 0.1 percent of revenue at the retail level; (c) overall, 54.1 percent of the incomplete exchange rate pass-through is due to local nontraded costs, 33.7 percent to markup adjustment, and 12.2 percent to the existence of price adjustment costs.