Association Exchange Rates and Prices

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American Economic Association

Exchange Rates and PricesAuthor(s): Rudiger DornbuschReviewed work(s):Source: The American Economic Review, Vol. 77, No. 1 (Mar., 1987), pp. 93-106Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/1806731 .

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Exchange Rates and PricesBy RUDIGER DORNBUSCH

The adjustmentf relative ricesto exchange ate movementss explained n anindustrial rganization pproach,usingvariousmodels. The extentof priceadjustment,iven aborcosts n therespectiveurrencies,s shown o depend nproduct ubstitutability,he relative umber f domestic nd foreign irms, ndmarket tructure.ome empirical vidence s offeredo support he heory.The large appreciation f the U.S. dollarover the1980-85 period and the subsequentdepreciation open important reas of re-search.The factofa large nd persistent ealappreciation poses a challenge for equi-librium theoriststo uncover the changein fundamentals.For those who explainmedium-termmacroeconomicsn termsofFischer-Taylorong-term age contracts,heepisode providesa striking xample of thedifferentialpeeds of adjustment f wages,goods, and assets prices. adopt thisper-spectivehereto explainthe determinantsfrelativeprice changesof differentroupsofgoods. Specifically, advance hypotheses

about those sectorswhere n exchangeratechange should lead to large relativepricechanges, nd otherswhere he relative riceeffectshouldbe negligible.The approach is to draw on models ofindustrial rganization o explain price ad-justments n terms f the degreeof marketconcentration,he extent f producthomo-geneity nd substitutability,nd the relativemarket haresofdomestic nd foreign irms.Models of industrial rganizationhave, ofcourse,been fruitfullypplied in trade the-ory; their applicationto macro-pricings-

sues, however,has been surprisinglylow.1There is a long-standing uestioningofpurchasingpower parity PPP), especiallyin the work of IrvingKravis and RobertLipsey 1978, 1984).2But so farthere eemsto exist ittleformal nalysis f price-settingbehavior n this ontext.3This paper adopts a partial-equilibriumapproach in that it assumes throughoutgiven, xogeneousmovementn thenominalexchangerate.The exchange ate movementand the less-than-fullylexiblemoneywageinteractto produce a cost shock forsomefirms n an industry-foreign irms n thehome market nd homefirms broad-andthusbringabout theneed foran industry-wide adjustment n prices. Althoughtheassumption of exogeneous exchange ratemovementsand stickywages is open tocriticism,t is a usefulworkinghypothesisfor he purposeof nvestigatingelative riceissues.Section I reviews some facts. Section IIoffers stylizedview of the link betweenexchange rates and prices, and the third

*Massachusetts nstitute f Technology, ambridge,MA 02139. I am indebted o OlivierBlanchard, tanleyFischer, Paul Krugman, Michael Rothschild, JulioRotemberg, ergio Sanchez, LawrenceSummers, ndJeanTirole. AvinashDixitprovided specially aluablesuggestions.An earlierversionof thispaper was pre-sentedat the1985 NBER SummerWorkshop nd theNBER Meeting on Business Fluctuations nd I ac-knowledgehelpful comments eceivedon those occa-sions. David Wilcox providedvaluable research ssis-tance.

1See Avinash Dixit (1984) and Elhanan Helpmanand Paul Krugman 1985) forextensiveworkon andreferences o trade applications. n the macrocontext,see OlivierBlanchard 1985), OliverHart (1982), andN. GregoryMankiw 1985).2For a reviewof thePPP literature,ee my papers(1985, 1986).3JoshuaAizenman 1985,1986) andAlbertoGiovan-nini 1985) investigate rice-settingehavior n thecon-textofexchangerate movements.heirfocus,however,is on short-termssuesof transactionsosts and uncer-tainty ather hanon the arge, ersistentmovementsnthe real exchangerate. See, too,themorerecent apersbyCatherineMann (1986),RobertFeinberg 1986),andEugene Flood (1986).93


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94 THE AMERICAN ECONOMIC REVIEW MARCH 1987section studies the behaviorof equilibriumprices.

I. SomeFactsThe large dollar movements re reflectedbothin absolute and relative rices.Table 1shows two measuresof the change n U.S.relative osts and prices: relative nit aborcosts and the relative alue-addeddeflatornmanufacturing.n each case, the U.S. seriesis deflatedby the correspondingime-seriesfor the trade-weightedverage n dollars ofour trading artners. he largemagnitudefthechange n relative ostsand prices risesfrom he factthatunit abor costs and pricesabroad (in national urrencies) ererising ta lowerrate than ntheUnitedStates.But atthe same time, hedollar,rather hanoffset-tingthe divergent rendby a depreciation,furthereinforcedhat ivergence ya strongappreciation.The depreciation ince mid-1985 has not been sufficiento eliminate hechange ncompetitiveness.Figure 1 shows absolute prices measuredby the U.S. GNP deflatornd thedeflatorsfor imports.Prior to 1980, import pricesincrease more rapidly hanthe deflator nd,to a lesserextent, o do exportprices notshown). During thisperiod,the dollar wasdepreciating. fter 980, however,he dollarappreciation etsunderway,ndimport riceincreasesslow down and ultimatelymportprices fall in absolute terms.Export pricestrack he GDP deflatormore losely, houghthepattern f divergencess similar o thatfor mports.At this broad level, t is clearthen that importpricesfell relative o thedeflatornd relative oexport rices.In the absence of comprehensive riceseries, able 2 showsunitvalues fordifferentexportand importgroups.The tablebringsout that he absolutedecline nimport ricesmustbe primarilyttributedo thefirsthreegroups,and not to finishedmanufactures.Oil price ncreases n 1979easilyexplainthedivergent attern fexport nd import nitvalues for crude materials.The interestingcomparison, herefore,s between the rela-tively homogeneous commoditygroups-food and semimanufactures-andfinishedmanufactures hereprice setting nd prod-

TABLE 1-RELATIVE COSTS AND PRICESIN MANUFACTURING(Cumulative ercentage hange)

1976-80 1980-85:1 1980-85:IVRelative Value-Added Deflator -14.7 49.3 27.0Relative UnitLabor Cost -12.6 59.8 22.0Source: International inanceStatistics, earbook 1985and August 1986.

Import rices 148140- 7~~~~ 136

+ 0/1, NP Def ator//'120 - +

+0

100 I I I l I I I1979 1980 1981 1982 1983 1984 1985 1986FIGURE 1. THE IMPACT OF DOLLAR APPRECIATION

uctdifferentiationre ikely o be important.For the formergroup, export and importunitvalues move roughlyn line,while forfinishedmanufactures,xports follow thedomesticprice trend and imports how amuchsmaller ncrease.II. Standard odels

There are two extrememodels of pricerelationshipsn theopen economyiterature.One assumes that the "law of one price"holds. Prices of goods are geographicallyarbitraged and, adjusted for tariffs ndtransport osts, they re equalizedin differ-ent ocations.Homogeneity,nformationndperfect ompetition ssure this result.4Let4For a review f PPP, see mypaper 1985).


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VOL. 77 NO. I DORNBUSCH: EXCHANGE RATES AND PRICES 95TABLE 2-UNIT VALUESOF IMPORTSAND EXPORTS(Index 1980:J 100)

Semi- FinishedFoods Materials manufactures manufacturesE M E M E M E M

1979:11 87 82 92 60 71 77 95 911980:1 100 100 100 100 100 100 100 1001985:1 94 87 91 97 86 82 139 106Note: E = Exports,M = Imports; ordefinitionnd source, ee theAppendix.

Pi, p,, and e denote theprice of good i inthe home country nd currency,he foreignprice, and the home-currencyrice of for-eign exchange.Arbitrage henmplies(1) pi=ep*.

In thisform, r in the first-differenceer-sionofGustav Cassel, the aw of one price sasserted n the PPP literature. he law ofone pricehas been applied n the monetaryapproach to exchangerates n combinationwith the quantity heory f money nd theassumption f full-price lexibilityo obtaina theory f the exchange ate.An importantimplication f complete patial rbitrage, otonlyfor ommodities utfor ll goods, s theidea that relativenationalprice levelsin acommon currency re independent f theexchange rate, since exchangerate move-mentsmerely eflect, assively, ivergenta-tional price trends.That is, of course,anapplication of the homogeneity ostulatewhichholds whenmoney s fully eutral.The alternativemodel might be called"Keynesian." Here it is assumed that eachcountrys fully pecialized n theproductionof "its own" good. Domestic and foreigngoods are less than fullyhomogeneous rsubstitutable.Wages are fixed n nationalcurrencies r at least sticky.LettingP and P * be the nationalGDPdeflators,he relative rice of domestic ndforeign goods or the real exchange ratethen, s(2) A= P/eP *If themarkup fpricesoverunit aborcosts

is constant, henfor givenunit abor costs,priceswillalso be given.Hence nthismodel,exchange rate movements hange relativeprices one-for-one.Exchange rate-inducedchanges n the relative riceaffect heworlddistribution f demand and employment.This approach tends to be used in openeconomyversions f the S-LM model n theMeade-Mundelltradition.Equation (1) would be a usefulmodelofinternational ricerelations or materials-say sisal, copper, tea-whereas (2) morenearly describeswhathappenswithmanu-factures.But the assumption f a constantmarkup s no longer ustifieds we shallnowsee when domesticand foreign irms avestrategicnteractionsn their ricing.

III. Equilibriumricing odelsTable 1 gave evidenceof large,persistentfluctuationsn exchangerate-adjusted ela-tive prices n manufacturing.n this sectionI exploretheoreticalmodelsthatwould ex-plain thesepricemovementss the result fchanges n relative nit abor costs.The basic assumption make s thatfirmsin any industryhave a linear technology,with labor as the only input. Unit laborcosts, w and w*, are given n home andforeign urrency,espectively.his assump-tionabout costs s combinedwith model ofpricing oyieldpredictionsbout thebehav-ior ofrelative rices.The experiments sim-ply this: the exchangerate change,say adollar appreciation,owers oreignnit aborcosts ndollars.As a result,hemarket qui-

librium s disturbed n each industry ndprice and output adjustmentsmust occur.


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96 THE AMERICAN ECONOMIC REVIEW MARCH 1987What these adjustmentsook like dependson three actors:5Market integrationr separation. s aparticular commodity traded in an in-tegratedworld market, r are there ignifi-cant barriers o restrictpatialarbitrage?Substitution etweendomestic nd for-eign variantsof a product.The extentofsubstitutionnfluences rice setting nd theoutputeffectsf costand pricechanges.Marketorganization.s the market er-fectly ompetitive,n whichcase firms reprice takers,or is the market mperfectlycompetitive r oligopolistic,n which casefirms re price setters nd may interactnstrategicways?Two models endthemselvesn a straight-forward ashion o formulatinghepricere-sponseto cost shocks fpartofthe ndustry.The Cournot model assumes perfect ub-stitutionbetween alternative uppliers ndplaces more emphasis on the extent ofoligopoly. t allows in principlemorevaria-tion n themarkupnresponse o cost shocks,and thushas thepotential or a richer at-ternof responseto cost shocks.The Dixit-Stiglitz 1977) model bycontrastmphasizesimperfect ubstitution etween alternativesuppliersand in its predictionsooks verymuch like the Keynesian model discussedabove. An alternative o the Dixit-Stiglitzmodel,again emphasizingroduct ifferenti-ation, s theSalop (1979) modelofcompeti-tion on a circle.

A. TheCournotModelIn theCournotformulation,he analyticalfocus s on a homogeneous ommodityold

in an oligopolisticmarket.Each selleras-sumes that other sellers defendtheir salesvolume. I assume thatthere s an effectivespatial separationbetween he home marketand foreignmarkets,nd discussthepricingin the U.S. market.For expository urposes, startwiththecase of a linear demand function:(3) Qd= a - bp,

* Jq

A

J*

O qFIGURE . THECOURNOTQUILIBRIUM

where all nonpricedeterminantsre cap-tured n the constant. here are n domesticsuppliers nd n* foreign irmswithrespec-tive sales of q and q * per firm.Aggregatesales of thesefirms, , havetosumtomarketdemand:(4) Q = nq+ n*q*.

Each firmmaximizes profits akingthesales of other firms s given.Profits f therepresentativeomestic nd foreign irmnthehome market re(5) q'=(p - w)

x [a - bp (n -l1)q - n*q*],nj= (p/e - w*)

X [a - bp- nq- (n* - I)q*]Maximization gives rise to the reactionfunctions shown in Figure 2. The homecountry's eaction unctions JJ,whileJ *Jrepresents he foreign ountry.They yieldthe Cournot-Nash equilibriumshown atpointA whichgives he quilibriumuantityallocation between representativeomesticand foreign irms. he common quilibrium5A fourthtemof relevance s the functional orm fthe demand curve. See JesusSeade (1983) and Dixit(1986).


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VOL. 77 NO. I DORNB USCH: EXCHANGE RATES AND PRICES 97price n the ndustrys given y(6) p = (nw + n*ew*)/N+ a/bN;

N n + +1.A dollar appreciation shifts the J *Jscheduleout and totheright,hus eading oincreasedforeignales and reduceddomesticsales. At the initial evel of sales foreveryother supplier, the individual foreign irmfaces a givenmarginal evenue chedule ndollars but experiences reduction n itsdollar marginalcost, and hence wishestoincrease output. In the new equilibrium tpoint A', foreign irmsncrease heir utputwhilehomefirmsontract. he ndustry ricedeclines, s seenfrom6).We are now interested n the extenttowhich exchangerate movementsor move-ments n relativeunit aborcosts)affect heequilibrium rice.The elasticityf theequi-libriumprice with respectto the exchangerate s(7) = (n */N)(ew */p).

The elasticityformulahas two determi-nants: the relativenumber f foreign irms(or the relativenumber f firmswithwagesnot fixed n dollars),and the ratio of mar-ginal cost to priceof foreign uppliers. inceboth termsare fractions,t is immediatelyclear from7) that dollarappreciationwilllowerprice ess thanproportionally.he de-cline in the dollar price s largerthe morecompetitivehe ndustryi.e.,the smaller hemarkupofpriceovermarginal ost) and thelarger the share of imports n total sales.This latter erm s represented y n*/N onthe assumptionof symmetrynd initiallyequal wagesbetween ountries.Equation (7) is interesting ecause itstretchesll thewayfrom he "small coun-try"case to the case whereexchangerateshave virtuallyno impact on home pricing.The small country ase, in the trade itera-ture, s the case where countrys a pricetaker n worldmarkets.n thatcase, a cur-rency depreciationwill raise prices in thesameproportion. his s,ofcourse, he imit-ingcase forperfect ompetitionnd a largenumber fforeign irmselative o the num-berofhomefirms.

The other extreme ase where exchangerate has no influence n home pricesresultswhen there are fewfirmsn the industry,most of which are domestic. n that case,foreign irms bsorb thedollarappreciationprimarilyn the form f extraprofits atherthan ncreased ales.The Cournot model thus potentially x-plainsbothunchanging rices nd steeppricedeclines.Themarket tructure-importhareand concentration-are the key parametersthat explainthe outcome.Considernext U.S. exportfirms ompet-ing in a foreignmarket.A dollar apprecia-tion will lower theirmarginalrevenue ndollars.Withunchangedmarginal ollar ost,thesefirmswill contract.n terms fFigure2 applied to the foreignmarket, ur scheduleJJshifts ownand to the eft.The commonforeign urrency rice rises,butin dollars tdeclines, hough ess thanproportionatelyothe appreciation.Using thesame model fortheforeignmarket, efind hat heelasticityofforeign ricewithrespect o theexchangerate s(8) *=-(nt/N *)(w/ep*),wheren' is thenumber f domestic irmsntheforeignmarket nd N * thetotalnumberof firms.With p* a negativefraction, hedollarpriceofexports, *e,has an elasticity1+ (p,and hencemustdecline n response oa dollar appreciation.Remembering hat the markets re sep-arated, et us look at thepriceof U.S. ex-portsrelative o thepriceof mports /ep*.In case of a dollar appreciation, ollar ex-port prices rise relative o importprices fthefollowing ondition olds:(9) sP>Iq+c*.

In principle, he condition an go eitherway. In the small country ase, export ndimport prices in dollars fall in the sameproportion s the currency ppreciates q =1, * = - 1), so that herelative ricep/ep*remains constant. n general, he outcomedepends on the relativeoligopolistic truc-tureof the two markets. xport priceswillrise relative o import rices n the apprecia-tion case, if at-home mport ompetitions


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98 THE AMERICAN ECONOMIC REVIEW MARCH 1987pervasive and foreignmarkets re stronglyaffected y U.S. suppliers s well as highlycompetitive.

Jesus Seade (1983) and Avinash Dixit(1986) have shown that the price effects fdisturbances n oligopolymodels are highlysensitive o the functional orm. t is there-fore nterestingo ask what happens withmore generalfunctional orm. or example,witha constantelasticity emandfunctionD = Ap exp(- /), the elasticity of equi-libriumprice with respectto the exchangerate becomes qp (n */N)(ew */W), whereN= n + n* and W= (n/N)w +(n */N ew *. The exchange ate mpact husdependsno longer ncost-pricemarkup nd,when costs are initially qual between oun-tries, s onlya function f the relative um-ber of firms.In generalthe elasticity f pricewithre-spect to the exchange ate s'(9'-) p= [n*/(N- 0)] (ew*1p) > O,where0 is the elasticity f the slope of theinversedemand curvewhich, or tability,sless than N. In the inear case, the formulareduces to (9) since 0 = 0. But, since 0 ispositive or zero), there s no upperboundon q. Frompublicfinance pplications,t isknown that tax disturbancesmay lead tomagnified rice adjustment nderoligopoly.I findthe same possibility ere for the ex-changerateeffectn prices.

B. TheDixit-Stiglitz odelThe representativeonsumern thismodelmaximizes a utilityfunctionV with con-sumptionof two commodities and x as

arguments:(10) V= U(z, x); X =(EXa )la

0 < a


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VOL. 77 NO. 1 DORNBUSCH: EXCHANGE RATES AND PRICES 99same formof demand curve as home firmsand hence they lso follow he samepricingrule,with he same markup, ut withforeignwages in dollars, ew*, as the base of theirpricing:(15) pj = aew*.

From (14) and (15), we have two strongpredictions: First the relativeprice of do-mestic and foreignvariants n the homemarketdepends ust on relativeunit laborcosts in a common urrency:(16) pi/pj= w/ew*.

Second, it is readily hownthattherela-tive price of a domesticvariant n terms fthe industryprice index (pi1P) is just afunction f the relativewage, w/ew*. Theelasticity f therelative ricewillbe(17) nzl/(n + n*z); z=(w/ew*)l/h.If wages are initially qual between coun-tries, he effect f an exchangeratechangeon the industryprice and on the relativeprice depends merely n thefraction f firmsthathas wagesfixednforeign urrency,ndhence experiences reduction f their ostsin dollars when the dollar appreciates.Giventhewages nhome and foreignur-rency, the Dixit-Stiglitzmodel providesstrong redictions bout the mpact fdollarappreciation:The prices of imported ariantsfall inproportion o thedecline f dollar unit aborcosts of foreign firms nd the prices ofdomesticvariantswould remainunchanged.Exporting irms t home, lthough heyhave to compete in foreignmarkets, tillfollow heirmarkuppricing n dollarwages.Accordingly, change n thedollar does notaffect heirdollarexportprice.Of course, tdoes affect heir ales and profits. dollarappreciationwillraise their oreign urrencyprice n the same proportion nd henceraisetheir elative rice n theforeignmarket.The strongprediction f the modelis tolook for sharp fall n import ricesrelativeto domesticpricesand to see exportprices

stay constantrelative o domesticpricesofthe same variant.This s, of course, heexactspecificationof the fixed-priceKeynesianmodel which s derivedhere as an implica-tion of given labor costs and an invariantmarkup.

C. An Extended ixit-Stiglitz odelThe Dixit-Stiglitzmodel assumesCham-berlinian mperfect ompetition nd henceeach supplier ssumes hathe does notaffectindustry price. Strategic nteractionwithother firms s thereforexcluded. But thesame structuref differentiatedroducts an

easily be adapted to introduce trategicn-teractionby way of a conjectural ariation.Assume, contrary o the preceding ection,thatthe ndividual irms sufficientlyarge oaffectndustry rice.Assume, oo,thatfirmsrespondto changes nthe ndustry rice, ndletthe conjectural ariation e theparametera, a fraction etween ero and one. Thus aone-percentage-pointise in the industryprice is assumedto cause each firm o raisetheirprice by a percent.Assuming givenconjecturalvariationrather han derivingtfrom dynamic ame-theoreticrameworksobviouslya shortcut.Nor is there nycon-cernherewith consistent onjectural aria-tions.With this adaptation,the demand curvefacingthe individualfirm's rice policynolonger s a constantmarkup ver unit aborcosts butrather ecomes(18) Pi =a'w; a'=1/[1-1/c(I-efl,where the term e=(dP/P)/(dPJ1Pi) cap-turesthestrategicnteractionetweenfirmsas perceivedby the individualprice-settingfirm. he terms a functionf relative ricesand theconjectural ariation:7

7The derivations as follows:maximizationfprofitsfor a domestic firm k in (13) yields +(Pk - w)c(E- l)/pk = O which yields the markupequation in(18). The elasticity of theaggregate rice evelwithrespect o a variationn an individual omestic rice kis derived as follows:from 12) we have ph 9h +

h +ypjh. Now assumingthat a=d lnpi/dlnPfor all firms and j otherthan k we obtain theelasticity f aggregate ricewithrespect o a variationin Pk.


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100 THEAMERICAN ECONOMIC REVIEW MARCH 1987

^ /H~~~~H

p? / 7pi HH ,,18~~~~~~~~~, Roo~ ~~~~~dH*

/~~~~~~ *0~~~~

H1,, Hw

O p. p. pFIGuRE 3. THE EXTENDED DIXIT-STIGLITZ MODEL

(19) ?< e(G,Pj/Pj)7'=-

[ +i n){n + jpi)


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VOL. 77 NO. 1 DORNBUSCH: EXCHANGE RATES AND PRICES 101and on thedistancend therelationshipsassumed inear:(21) h= v- c--p,wherev is a constant, denotes heutilitycostperunit istance romhe est ocation,and p is the price of a particular irm.Consumers illbe indifferentetween hebrands fferedy twocompetingirms neither ide of their referredocation f theconsumers' urplus s the ame,hi= hi.Tak-ing thecase of n firms hatare equallyspacedon the ircle, he onditionorndif-ference etween domestic nd a foreignsupplier s(22) v-CT-p*=V-C(Iln-T)-P.Hence thedistanceerved y a foreignirmis an ncreasingunctionfthe rice hargedbydomestic irmsnd a decliningunctionof tsownprice:(22') T=(p+c/ln-p*)/2c.Profitsor heforeignirmreequal to2Lxtimes he xcess fprice vermarginalost:(23)

IT* (p*-ew*)2L( p + c/n-p*)/2c,where denotes he totalnumber fcon-sumers ndhence alsorepresentsheden-sityper unitdistance erved y thefirm.Since thefirm erves oth idesof ts oca-tion, LLT s thetotalnumber funits old.Maximizationakingomesticrice s givenyields heforeigneactionunction:(24) p* = (p+c/n+ew*)/2.Thetypicalomestic irm'seaction unctionis derivedn the amemanner:(25) p = (p* + c/n + w)/2.From 24) and (25), weobtain he olutionfor heprices harged y home ndforeign

firms:(26) p=c/n+(ew* +2w)/3;

p * = c/n + (2ew* + w)/3.From 26),we cancalculate he lasticityofpriceswith especto the xchangeate nthismodel:

(27) p9 (1/3) (ew */p);* = (2/3)(ew*/p*).

Note thatthese lasticitiesnce again arefractions.fwages nd hence rices re ni-tially qual, w= ep *, theelasticitiesimplifytothefollowingxpressions:(27') q=4/3;

= 24'/3; 4--1/(1+ c/nw).The elasticitieshow hat herelativericeof imported oods declines nd thatthechangen therelativerice4/3 is smaller,thesmaller henumber ffirmsn the n-dustry,nd the ower he ubstitutabilitysmeasured y the term . Along withthechangenrelativerices, here ill e a shiftindemand rom ome irmsoforeignirmsas consumersrade ffhe eductionnpricefora largerdistance rom heirmost-pre-ferred randocation.At thispoint,t is worthommentingnthepropertiesfthe quilibriumhen hereisnot nalternatingatternetweenomes-tic and foreign irms.pecifically,upposethatthere refive irms,wodomestic ndthree djacentforeign irms.t is apparentthat hemiddle oreignirmompetesnlywithforeign irms,nd hencewill cut itspricemorethantheoutlyingoreign irmsthatcompetewithhomefirms hichhavenot xperiencedcost eduction.ence herewillbe three rices.The same modelcan be appliedto theforeignmarket. n terms f foreignx-change, hepriceswillrise ndtherelativepriceof ourexport randsbroadwillrise.But,because t rises roportionallyessthanthe urrencyppreciates,he xport ricen


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102 THE AMERICAN ECONOMIC REVIEW MARCH 1987dollars changes n the proportion:(28) qV=1-24*/3; )*=1/(1+c/nn*w),where n* is the total number f firms erv-ing the foreignmarket.We can thereforefind the change in the relativeprice ofdomestic xports n terms f imports nd interms f home brands:(29) T -q* =1-2(4 +4*)/3;

9)' 9=1-24*/3-+ /3.The first oint to note s that xport ricesmayriseor fall n terms f mport rices s a

result of appreciation. But the fewer thenumber of firmsn each country, hemorelikely hat an appreciation eads to a fall inthe relativepriceof exports.By contrast,sthe numberof firmsncreases and hence4and 4 tendto unity), he relative riceofexports mustrise, reflectinghe increase nthe relativeunit labor cost at home whichsets competitive elative rices.The secondpoint s that xport ricesmaydecline relative o domestic rices s a resultof an appreciation. his mustbe the case ifthe numberof firmsn the two markets sthe same (4)= 4 ). As thenumber f firmsincreases, herelative rice tendsto remainunchanged.This result risesbecause pricegets competeddown to marginal ostwhichis the same forhome and export roduction.It is apparentfrom 29) that the change ntherelative rice n terms f mportables illalways be larger than that in terms ofdomesticgoods.

E. SummaryWe have now seen commonfeatures f anumberof models: they ll predict hatap-preciation should lead to a decline in thepriceof mports.n the ase ofhomogeneousgoods,domestic irms,fcourse, ullymatchthe decline n price. fproducts re differen-tiated, t will always be the case that therelativeprice of the importedbrands de-clines in responseto an appreciation.Theextentof thedeclinedependson a measure

of competition nd on the relativenumberof home and foreign irms.

The empirically establehypotheses on-cern price-marginal ost markups and thebehaviorofrelative rices.For differentiatedproducts, t is always the case that exportand domesticprices will stay closer n linethan import and domesticprices. In theDixit-Stiglitzmodel, importsfall in termsof domestic goods and the relative riceofexports goods stays unchanged n terms fhome goods. In other models, the exportprice can in principle vendecline n termsof imports.

IV. SomeEvidenceEconometric esting f the hypotheses sunfortunatelyrecluded ytheabsence of acomprehensivematcheddata set of export,import, nd domesticprices.The BLS nowpublishes ransactions ricesfor xports ndimports hatare disaggregatedo the4-digitlevel and classified n theSIC basis.But fewof the seriesgo backbeyond heearly 980's.Where hey o, therevisions f theSIC-basedU.S. producerprices n most ases areeithernot all available yet, or only go back veryfewyears.A completeoverlapbetween x-

port, mport, nd domesticprices formorethan two years apparently nly exists forfewer han a handfulof cases, and overlapbetween nytwoseries s limited olessthana dozen.At a more nformalevelthere re nterest-ing patternsto observe. First, consider acomparisonof U.S. exportprices n dollarswith thoseof Germany nd Japan.Table 3shows the percentage oss in U.S. com-petitivenessover the period 1980:IV to1984: V, usingas a sample ll availabledataat a highly disaggregated evel. In theU.S.-Germany comparison,here re36 dif-ferentmatched ime-series,ntheU.S.-Japancomparison,there are 20. Typical items nthe list of commodities re "gears and gearunits,"or "household electrical pace heat-ing."The data do not allow us to tell whetherthesearepricesofthe sameproducts old inthe same third market say France), orwhether hey represent xports o differentmarkets say U.S. sales to France and Ger-man sales in the United States). Accord-


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VOL. 77 NO. 1 DORNBUSCH: EXCHANGE RATES AND PRICES 103TABLE 3-CHANGES IN RELATIVE PRICES:U.S. VS. GERMANY AND JAPAN(Percentage hange nrelative xport rices:1980:IV-1984:IV)

U.S.-Germany U.S.-JapanMean 39.3 24.9StandardDeviation 6.1 8.3Source: See theAppendix.

TABLE 4-CUMULATIVE PRICE CHANGE:1980:IV-1985:1ExportPrices Import rices

Non-ElectricalMachinery 18.0 - 10.1Scientificnstruments 18.0 - 13.4Source: See theAppendix.

ingly,wecannottellfrom hesedatawhethertheyreflectmarket egmentationr imper-fect ubstitution.hey re onsistent ithmar-ketsbeing segmented, ut goods being per-fect ubstitutes nd having commonpricein the same market ndependent f supplysource. But they are also consistentwithmarkets eing ntegrated-a commonworldmarket-but goods being imperfect ub-stitutes o that therelative riceof differentsuppliers an change.Consider next a comparison f thetrans-actionspricesof U.S. exports nd U.S. im-ports n the same commodity roup.Thereis overwhelming vidence that, virtuallywithout xception, hedollar appreciation f1980-85 has been accompanied by an in-crease in the price of exportsrelative toimports. Evidence in this direction omesfrom xport-importrice omparisons t themorenarrow2- and 4-digit evel. An exam-ple is provided nTable 4 which howsdatafor wo2-digitndustries.Figure4 shows theratio of exportpricesto import prices for telecommunicationsequipment nd fornonelectricalmachinery.The figure lso showthe ndex of thenomi-nal dollar exchangerate index. The dollarappreciation ince 1980 givesrise to an in-crease in the relativeprice of exports ntermsof imports.Table 4 shows ndices ofthe relative xport-importricefor ll series

151

-e134130 XDol lar /120 - Telecommunications

Equipment

100 0-9090 I l l l l l l I77 78 79 80 8 1 82 83 84

151

140_ Dollar

120 - 0-0-.O'Oo / 0,0?' 116

o Non -E lectrical100 o' Machinery0-o, 0'

I II I I i I I77 78 79 80 8 1 82 83 84FIGURE 4

wherecomparable SIC data exist.The samepatternwould be obtained by comparingU.S. to German and Japanese xportpricesin these individual commodity roups.Thefirst inding hen is, that across industries,virtuallywithout exception, export priceshave increasedrelative o import rices.Thisis true at the level of individual ommod-ities,but also, as shown t the outsetof thepaper,foraggregate xport nd import nitvalues.This resultwould obtain strictlynly intheDixit-Stiglitzmodel. n theotherformu-lations, t is a possibility hough t need notoccur. Tables 5-7 look at thepriceof ex-portsand imports elative o each other nd


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104 THE AMERICAN ECONOMIC REVIEW MARCH 1987TABLE 5-THE RATIO EXPORT TO IMPORT PRICES(Index 1980:I = 100)

2011 301 35 353 356 3569 357 3643 381979:IV 105 103 - 100 95 96 - 91 921981:IV 108 105 112 118 119 121 106 115 1081985:1 126 104 131 135 152 143 110 152 136Note: The headings re SIC codes.For definitionsnd source, ee theAppendix.

TABLE6-THE RATIO OF EXPORT TO DOMESTIC PRICES(Index1980:IV= 100)3546 3555 3674 3533 3523 3519 3494 2011 3537

1979:IV 101 101 109 99 99 103 99 110 971981:IV 100 104 91 100 100 103 103 93 991985:1 95 107 93 100 102 105 108 108 100Note: See Table 5.

TABLE 7-THE RATIO OF IMPORTTO DoMESTIc PRICES(Index1980:IV= 100)2311 2033 3651 3143 3531 2435 2011 3312 3313

1979:IV 100 108 - 96 98 120 105 101 881981:IV 101 92 100 95 90 114 92 98 881985:1 110 90 92 88 76 102 85 84 74Note: See Table 5.

relative to domesticproducerprices n thecommodity roup. Exportpriceschange it-tle relative o domesticprices, ven thoughthere s no clear patternof decline in allindustries.By contrast,most importpricesdecline n terms f domestic oods. But theorder of magnitude f the decline remainsrelatively mall compared to the change nrelativeunit labor costs. With a change nrelative unit labor costs of more than 40percent, he decline n therelative rice s inmost cases less than20 percent. hat is notat all out of linewith hetheory nce somedegreeof "pricing to the Americanmarket"is taken nto account, ust as the price-set-tingmodels above suggest.It is worthnoting hat, t the retail evel,this effectwould obtain evenmore trongly.The reason is that here distribution ostscome into play, so that evenwiththe fullpass-throughfcost reductionsn importedgoods, theproportional ecline n the price

of imported oods would be much ess thanthe exchangerateappreciation.V. Concludingemarks

The models reviewed n thispaper focuson a relatively hort timeperspective. hewage rate s assumednot to reactto changesin output and profitability,nd the numberand location of firmsn an industrys un-affected. hese assumptions re plausible ntheshort erm, ut t s clear that sustainedreal appreciation will ultimately how itseffectsnwagecuts nthose ndustries herethe oss in competitivenessausesunemploy-mentand wage increases n the expandingsectors.Firms will close in high-wagereasand entry nto an industry illtakeplace inareas where labor costs are low. Theselonger-termdjustments re also part of themacroeconomics f adjustment o exchangerate movements.They implythat the ab-


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VOL. 77 NO. 1 DORNBUSCH: EXCHANGE RATES AND PRICES 105solute and relativenumbers ffirmsn andn*) will be endogeneous s thelocationoffirms n theproduct ircle.

It is clear from he analysisoffered erethat for theseissues,a microeconomic er-spectivewillalso be helpful.n particular,twill be interesting o see how pricingdeci-sions are affected y entry nd relocationpossibilities t an internationalevel, nd bytheanticipated ersistencefdisequilibriumexchangerates.The analysis developed here has appli-cation not only to theexchangerateques-tion, but also to the short-termffect ftradeliberalization. he commonargumentis thata small country y opening up cantake advantageof the worldmarkets,njoy-ing price reductions n proportion o thetariff eduction. hatclearly ssumesperfectcompetition. f markets re less than fullycompetitive, he analysis offeredhere be-comes relevant to the trade liberalizationissue.

DATA APPENDIXThe data in Table 2 are unitvalues obtainedfrom

Data Resources, nc., U.S. CentralData Bank.The data in Table 3 are compiledby the BureauofLabor Statistics, ivision of International rices.Theunpublished data are from a compilationentitled"Comparisons of U.S., Germanand Japanese ExportPrice ndices," datedMay 1985.The data for xport nd import rices n Tables 4-7are SIC-based price data compiledby theBranchofExport and Import Price Indexes of the Bureau ofLabor Statistics.The data are from printout, atedJuly1985. The domestic price index for SIC-basedproducerprices s obtained fromData Resources, nc.Table 4: The data refer to SIC codes 34 and 38,respectively.n Tables 5-7, thefollowing re thedefini-tions of theSIC codes shown n the tableheading:Table 5: 2011-Meat and Meat PackingProducts;301-Tires nd InnerTubes; 35-Machinery,xceptelec-trical;353-Construction, ining quipment; 569-Gen-eral IndustrialMachines; 357-Office, omputing ndAccountingMachinery;3643-Current-CarryingiringDevices; 38-Scientific nstruments,Optical Goods,Clocks.Table 6: 3546-Power-Driven and Tools; 3555-Printing rades Machines, Parts; 3674-SemiconductorDevices; 3533-Oil ndGas FieldEquipment; 523-FarmMachinery nd Equipment;3519-Internal ombustionEngines; 3494-MetalValves, Pipe Fittings; 011-Meatand Meat-PackingProducts; 3537-Industrial rucks,Portable Elevators.Table 7: 2311-Men's or Boy's Suits & Coats, ex-cept Raincoats; 2033-Canned and PreservedFruits,

Vegetables,Jams,Juices; 651-Video nd Audio Equip-ment;3143-Men'sFootwear xceptAthletic; 531-Con-struction Machinery; 2435-Hardwood Veneer andPlywood; 2011-Meat and Meat-Packing Products;3311-RollingMill Products;3313-ElectrometallurgicalProducts.The index of the nominaldollar exchangerate inFigure4 is theMorganGuaranty radeweightedndexof the dollar.The serieswas obtained fromData Re-sources, nc. The seriesfor telecommunicationsquip-ment and non-electricalmachinery re unpublished,SITC-based prices of exportsand importsobtainedfromthe Division of International rices, Bureau ofLabor Statistics.

REFERENCESAizenman, Joshua, "Monopolistic ompeti-tion and Deviations fromPPP," unpub-lishedmanuscript, niversity f Chicago,1985.,"Testing Deviations fromPurchas-ing PowerParity PPP)," Journal f nter-nationalMoneyandFinance,March1986,5, 25-35.Blanchard, livier, Monopolistic Competi-tion, Small Menu Costs,and Real Effectsof Nominal Money," unpublishedmanu-script,MIT, 1985.Dixit,Avinash,InternationalTrade Policyfor Oligopolistic Industries,"EconomicJournal, uppl. 1984, 94, 1-16.,"Comparative tatics orOligopoly,"International conomicReview,February1986, 27, 107-122.

_ and Stiglitz,Joseph," MonopolisticCompetition and OptimumProductDi-versity," merican conomicReview,June1977, 67, 297-308.Dornbusch,udiger,FlexibleExchangeRatesand Interdependence,"MF Staff apers,March 1983, reprinted n Dollars, DebtsandDeficits, ambridge:MIT Press, 986."PurchasingPower Parity,"NBERWorkingPaper No. 1591, 1985, in Pal-grave's Dictionary fEconomics, ondon:Macmillan,forthcoming.) "Inflation, Exchange Rates andStabilization,"Essays in Internationali-nance, International Finance Section,PrincetonUniversity,986.Giovannini, lberto, Exchange Rates andTraded Goods Prices,"unpublishedman-uscript, olumbiaUniversity,985.


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106 THE AMERICAN ECONOMIC REVIEW MARCH 1987Feinberg,Robert M., "The InteractionofForeign Exchange and Market PowerEffects on German Domestic Prices,"Journalof Industrial conomics, eptem-ber 1986, 61-70.Flood, ugene, r., An EmpiricalAnalysis fthe Effects f ExchangeRate ChangesonGoods Prices," unpublishedmanuscript,StanfordUniversity,986.Hart,Oliver,A Model of Imperfect ompe-titionwithKeynesianFeatures,"QuarterlyJournal f Economics, ebruary 982, 97,109-38.Helpman, phanan,ndKrugman,aul,MarketStructure nd ForeignTrade, Cambridge:MIT Press,1985.Kravis,rvingndLipsey, obert,Price Behav-ior in the Light of Balance of PaymentsTheories," Journalof International co-nomics,May 1978, 8, 193-246.and _, "Prices and Terms of

Trade forDeveloped Country xportsofManufacturedGoods," in B. Csikos-Nagyet al., eds., The Economics of RelativePrices, New York: Saint Martin'sPress,1984.Krugman,aul, "Pricing to Marketwhen theExchangeRate Changes,"NBER WorkingPaper No. 1926, May 1986.Mankiw, . Gregory,Small Menu Costs andLarge Business Cycles:A MacroeconomicModel of Monopoly,"Quarterlyournal fEconomics,May 1985, 100, 529-37.Mann,Catherine,Prices,ProfitMargins ndExchange Rates." Federal ReserveBulle-tin,June1986, 72, 366-79.Seade, Jesus, Prices, Profits nd Taxes inOligopoly,"Working aper,UniversityfWarwick, 983.Salop, Steven, "Monopolistic CompetitionwithOutsideGoods," Bell Journal fEco-nomics, pring1979, 10, 141-56.

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