Exchange Rate Pass-Through in Vertically Related Markets

We provide a theoretical framework which addresses exchange rate pass-through within the setting of vertically related markets. In particular, foreign firms' price adjustment in response to an exchange rate shock is evaluated. This framework enables us to study the importance of cost effects of the exchange rate shock. Recent empirical evidence in Athukorala and Menon (1994) and Campa and Goldberg (1995, 1996) indicates the relevance of these cost effects. We show that one can decompose the effects on an exchange rate shocks on the final good market into a direct and indirect component. The indirect effect works through the input market. The degree of pass-through then depends on the relative importance of direct and indirect effects, which in turn depends on the nature of vertical structures and strategic firm behavior. We show that the institutional aspects of vertically related markets, i.e. vertical integration or vertical separation, play a role in explaining incomplete price adjustments in both intermediate and final good markets and the failure of PPP in the short run