Multinationals and Exchange Rate Pass-Through

The authors examine the impact of multinational enterprises (MNEs) on exchange rate pass-through in an environment where an MNE engages in Cournot (quantity) competition with domestic and foreign rivals. The MNE differs from its competitors because it has a lower marginal cost as a result of increased efficiency, and economies of scope as a result of operating in two markets. An MNE can also choose to locate its production for the foreign market domestically (in the location of the MNE's parent), or in the foreign country (the location of the subsidiary). When it locates all its production domestically, it engages in <em>intrafirm trade</em> (IT) in final goods. Otherwise, it is said to engage in <em>international production</em> (IP). Consistent with other studies on exchange rate pass-through under imperfect competition, the authors' analysis shows that exchange rate pass-through into domestic and foreign prices is incomplete. Moreover, the presence of an MNE increases the sensitivity of domestic market prices, and reduces the sensitivity of foreign market prices, to exchange rate movements, relative to arm's-length trade. Furthermore, IT domestic and foreign prices are more sensitive to exchange rate movements than their IP counterparts, and react in the opposite direction. The authors' results indicate that it is important to distinguish between the domestic and the foreign market when looking at the sensitivity of prices and their direction of change. This could potentially explain why some empirical studies find IT prices more sensitive to exchange rate movements and others find them less sensitive.