Reserve Bank of Australia Bulletin May 1993

DEVALUATION AND INFLATION1

Since September 1991, the value of the This article reviews the process by which Australian dollar has depreciated by about changes in the exchange rate ‘pass-through’ 13 per cent in Trade-Weighted Index (TWI) to domestic prices. terms. Depreciation increases the domestic The process of exchange rate pass-through price of internationally-traded goods and occurs in two stages. The first stage concerns tends to put upward pressure on the general the response of foreign suppliers. They might price level. Historically, currency reduce their foreign currency prices in depreciations in Australia have been response to a devaluation, with a view to accompanied by increases in inflation, maintaining their share of the Australian although this has not been the experience in market, or they might choose to hold their the current episode. As Graph 1 shows, the foreign currency prices unchanged. In the increase in import prices following the recent second stage, local distributors may reduce exchange rate depreciation has not been or maintain their margins when setting the reflected (at least to this point) in a pick up in price they charge local customers. The final the CPI. impact of an exchange rate change on

EXCHANGE RATE AND PRICES consumer prices will be determined by the Sep 76, Jun 84 and Sep 91 = 100 responses made at both stages of this process.

Index Index The focus here is mainly on the first stage 160 160 (based on import prices ‘over the docks’), but Inverse some remarks are also offered on the second TWI stage. 140 140 Import Import prices prices Import prices 120 120 FIRST STAGE IMPORT Inverse Inverse TWI CPI TWI PRICE PASS-THROUGH CPI 100 100

CPI Graph 2 compares actual import prices with 80 80 74/75 76/77 78/7983/84 85/8689/90 91/92 a hypothetical measure that shows what would have happened if foreign suppliers made no Graph 1

1. This article is based on work by J. Dwyer, C. Kent and A. Pease, which appeared in ‘Exchange Rate Pass-Through: The Different Responses of Importers and Exporters’, Reserve Bank of Australia Research Discussion Paper No. 9304, May 1993. 1 Devaluation and Inflation May 1993

IMPORT PRICES IMPORT PRICES 1989/90=100 Cumulative response to exchange rate change

Index Index % % 120 120 1.0 1.0 Instant pass-through Actual 100 100 0.8 0.8

80 80 0.6 0.6

60 60 0.4 0.4

40 40 0.2 0.2

20 20 0.0 0.0 74/75 77/78 80/81 83/84 86/87 89/90 92/93 02341 5678 Quarters after initial depreciation Graph 2 Graph 3 modification to the foreign prices at which depreciation occurs. One quarter later, import they supplied the Australian market, and the prices have risen by almost 0.8 per cent. It full effect of the exchange rate change was takes four quarters before the depreciation instantaneously passed on. This hypothetical effect passes through completely. These results measure is based on general export price are typical of each depreciation of the deflators of Australia’s foreign suppliers, i.e. Australian dollar since December 1983, the price at which they supply the world including the depreciation since late 1991. market. If foreign suppliers respond to movements in the exchange rate for the $A by changing the price at which they supply SECOND STAGE IMPORT the Australian market, this would show up as PRICE PASS-THROUGH a divergence from the hypothetical series. There could also be short-term divergences if, for example, import contracts were The near-full pass-through of the first- denominated in Australian dollars. Broad round effects is consistent with Australia, as a trends in the hypothetical and actual import small trading nation, being a price-taker in prices are relatively close, with short-run world markets. To assess how this impinges divergences lasting up to about one year. This on inflation, however, it is necessary to know suggests that while there may be some how the prices ‘over the docks’ pass through evidence that foreign suppliers temporarily to final consumer prices. This process cannot absorb fluctuations in prices caused by be considered independently of the particular exchange rate movements, in practice the circumstances of the time, including: the state pass-through to prices ‘over-the-docks’ tends of demand in the economy; the factors causing to be relatively rapid. the exchange rate to depreciate; and the It is possible to estimate the speed of this general inflationary environment. pass-through more precisely with quantitative Nevertheless, with these caveats in mind, a techniques. This was done for the period from few observations can be made in respect of the mid 1970s to December 1992. Graph 3 recent developments. summarises the typical effect on domestic Graph 4 compares prices of imported import prices of a 1 per cent depreciation. consumption goods ‘over the docks’ with the Import prices are estimated to rise by about import component of the retail price index. 0.5 per cent during the quarter in which the These series have been adjusted to ensure that

2 Reserve Bank of Australia Bulletin May 1993 IMPORT PRICES AT THE SECOND STAGE 1992), prices at the retail level rise less quickly Dec 1984 = 100 than would be suggested by ‘over the docks’ Index Index prices, indicating that importers and 170 170 Retail price of imported goods distributors cut their margins. When the 160 160 exchange rate is rising, this process seems to 150 150 be reversed. 140 140 Imported This evidence suggests that the inflationary consumption goods 130 130 (over the docks) consequences of exchange rate depreciations

120 120 can be reduced considerably – at least for a time – by the pricing policies of domestic 110 110 importers and distributors. The ability of 100 100 distributors to ‘catch up’ margins lost in the 90 90 most recent episode will be constrained by the 84/85 86/87 88/89 90/91 92/93 current low-inflation environment. If the general level of prices is rising only slowly, then Graph 4 large relative price movements are more their components are as comparable as conspicuous. If the domestic prices of possible, within the limits of data availability. substitute products have not changed, the It seems that when the exchange rate is under scope for altering the retail price of imported downward pressure (as in 1985, 1986 and products will be reduced.

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