Exchange-rate pass-through

Formally, exchange-rate pass-through is the elasticity of local-currency import prices with respect to the local-currency price of foreign currency. It is often measured as the percentage change, in the local currency, of import prices resulting from a one percent change in the exchange rate between the exporting and importing countries. A change in import prices affects retail and consumer prices. When exchange-rate pass-through is greater, there is more transmission of inflation between countries. Exchange-rate pass-through is also related to the law of one price and purchasing power parity. Subsequent theoretical work has shown that the degree of pass-through also depends on the structure of vertically related markets, with the effect of an exchange-rate shock decomposing into a direct component and an indirect component working through imported-input costs; pass-through tends to be higher under vertical integration than under vertical separation.

Example

Suppose that the US imports widgets from the UK. The widgets cost $10 and £1 costs $1. Then the British Pound appreciates against the dollar and now £1 costs $1.50. Also suppose that the widgets now cost $12.5

There has been a 50% change in the exchange rate and a 25% change in price. The exchange rate pass-through is

${\displaystyle \frac{25\mathrm{\%}}{50\mathrm{\%}}=.5.}$

For every 1% increase in the exchange rate, there has been a .5% increase in the price of the widgets.