Written by Mary Amiti, Oleg Itskhoki, and Jozef Konings from Liberty Street Economics

Changes in exchange rates directly affect import prices. Since the beginning of 2014, the U.S. dollar has strengthened by 17 percent against the currencies of its major trading partners while import prices have fallen by 4 percent. The pass-through from exchange rates into import prices in the United States is estimated to be quite low, at around 30 percent, and this is often attributed to the fact that imports are mostly invoiced in U.S. dollars. In addition to this direct impact of exchange rates on import prices, there can also be an effect on domestic prices.

Suppose that a stronger U.S. dollar means that cars imported from Japan will be cheaper for U.S. consumers. If domestic auto producers do not then reduce their U.S. prices they could lose market share. By how much do they adjust their prices? In this post, we draw on a new study – “International Shocks and Domestic Prices: How Large Are Strategic Complementarities?” – that uses micro-level data for Belgian firms to shed light on this question.

An exchange rate shock can affect domestic prices through two distinct channels. The first is a direct effect through the marginal cost channel, as the exchange rate alters the price of imported inputs. Continuing with our car industry example, a stronger U.S. dollar makes imported intermediate inputs – such as car parts, steel, and rubber – cheaper so the marginal cost of producing a car in the United States is lower. This effect will be larger for firms that source a larger share of their inputs from abroad. The second, more indirect effect, is through the markup channel. Imported final goods, foreign cars for example, are also cheaper due to the strong dollar. As a result, domestic car producers may lower the price of cars produced for the U.S. market in order to maintain market share even if they do not import intermediate inputs. That is, domestic prices of final goods may change purely in response to a change in competitor prices – even without any change in their marginal costs. This would result in lower markups for U.S. firms. We refer to this effect as strategic complementarities.