A Pass‐Through Revival

• Published date: 01 January 2014
• Date: 01 January 2014
• Author: Etsuro Shioji
• DOI: http://doi.org/10.1111/aepr.12053

A Pass-Through Revival

Etsuro SHIOJI†

Hitotsubashi University

It has been found that the pass-through of the exchange rate and import prices to domestic prices

has weakened over time. The most recent research,however, shows that this trend may have been

reversed. Recent studies have applied various time series methods to the Japanese data, and esti-

mated responses of domestic prices to the exchange rate and import prices in different time

periods. Those studies have found signs that pass-through has made an impressive comeback since

the early 2000s. This paper reviews the most recent evidence and discusses its policy implications. I

argue that the exchange rate has likely regained its status as an important transmission mechanism

of monetary policy to domestic prices.

Key words: domestic prices, exchange rate, imported inputs, monetary policy, pass-through

JEL codes: F41, E31

1. Introduction

This paper discusses the most recent evidence on pass-through in Japan. Here, pass-

through means the effects of the exchange rate and import input prices on domestic

prices. There is a wide agreement in the literature that this pass-through declined over

the past decades. However, the most recent research suggests that it has made an impres-

sive comeback lately. Shioji (2013a) estimates various vector autoregressive (VAR)

models and finds such a tendency. Shioji (2013b) employs a more sophisticated method-

ology called the time-varying parameter VAR (TVP-VAR), which allows for the possibil-

ity that the dynamic relationship between economic variables might evolve over time.

This method enables him to estimate the extent of pass-through at different points in

time. The results confirm his earlier findings.

In this paper, I review this recent evidence by estimating empirical models in the

spirit of Shioji (2013a, b). I also discuss some policy implications of these findings. I shall

argue that this apparent revival of pass-through likely means that the central bank has

regained an important transmission mechanism of its policy to the private sector. This

I would like to thank the discussants at the Asian Economic Policy Review (AEPR) Conference

(July 15, 2013), KiyotakaSato and Yushi Yoshida, for their insightful comments. I would also like to

thank the conference organizers, Takatoshi Ito, Kazumasa Iwata, Colin McKenzie, Shujiro Urata,

and TsutomuWatanabe, for helping me improve the paper, as well as the other conference partici-

pants. Much of the author’s knowledge reflected in this paper has been developed through a series

of joint research with Taisuke Uchino (Daito Bunka University). I am also indebted to Jouchi

Nakajima (Bank of Japan) for his enlightening comments about the statistical methodology and

matlab coding. Needless to say, all the remaining errors are my own responsibility.

†Correspondence: Etsuro Shioji, Department of Economics, Hitotsubashi University, 2-1Naka,

Kunitachi, Tokyo 186-8601, Japan. Email: shioji@econ.hit-u.ac.jp

bs_bs_banner

doi: 10.1111/aepr.12053 Asian Economic Policy Review (2014) 9, 120–138

© 2014 The Author

Asian Economic Policy Review © 2014 Japan Center for Economic Research

120

has a particularly important implication when the economy is at the zero lower bound of

the interest rate, where the monetary authority lacks other effective tools to influence the

private sector.

The rest of the paper is organized as follows. Section 2 discusses the background of

the current paper and the economic significance of the pass-through issue. Section 3

overviews the Japanese data on the exchange rate, import prices, and domestic prices,

which will be utilized in later sections. Section 4 presents evidence based on the (regular)

VARs,while section 5 estimates TVP-VARresults. Section 6 tries to understand economic

reasons behind the pass-through revival. Section 7 contains a conclusion.

2. Background

2.1 Importance of the pass-through

The extent of pass-through influences the way the domestic economy responds to fluc-

tuations in the exchange rate and imported input prices. Suppose that the yen has just

depreciated. Its effect on the Japanese economy will depend crucially on the degree to

which this depreciation is reflected in the prices (in yen) of imported raw materials and

intermediate goods, as well as those of the domestic goods that are produced using those

imports. If the degree of pass-through is small, there will be less inflationary pressure on

the domestic economy.This means that Japanese households and firms at downstream of

production chains will suffer less from higher prices of goods that they purchase. (On

the other hand, a Japanese firm that is in direct competition with imported products

could gain if its rivals’ prices went up more, not less.) At the same time, the volume of

imports may not decrease as much as it would in a high pass-through environment.

The extent of exchange rate pass-through depends both on the pricing behaviors of

foreign firms exporting to Japan (which would affect the rate of pass-through to Japa-

nese import prices) and the reactions of Japanese firms that import those goods and

(usually after some processing) sell the final products to Japanese consumers. The

former, the degree of pass-through to import prices, would be lower when foreign

exporters, facing competition with local firms, try to stabilize their prices in the Japanese

market. This behavior is called pricing to market. This argument is especially relevant

when foreign exporters are selling differentiated consumer products to Japan.1Another

crucial determinant, at least in the short run, is the currency of invoicing. The latter, the

reaction of domestic prices to import prices, depends on (i) the importance of imported

inputs in the overall production cost; (ii) the strength of the desire of domestic produc-

ers who use those imported inputs to stabilize their output prices against their competi-

tors; (iii) the responses of distribution margins and transportation costs; and (iv) the

overall degrees of price stickiness.2

2.2 Monetary policy and pass-through

If the extent of pass-through is large, it could serve as an important transmission channel

for monetary policy. In recent years,an increasing number of central banks have adopted

an inflation rate as their primary policy target. For example, the Bank of Japan (BoJ)

Etsuro Shioji A Pass-Through Revival

© 2014 The Author

Asian Economic Policy Review © 2014 Japan Center for Economic Research 121