According to Bhagawati (1991) the phrase “pass-through” was first used in economics literature by Steve Magee (1973) in his paper while explaining the impact of currency depreciation. Since then the concept has been widely used in the literature. In the case of international trade the suppliers of commodities deal with two currencies, the domestic currency against which commodities are procured, and the destination currency, the currencies of the importing country. Similarly, the importers of the commodities also face two currencies. With the breakdown of the Bretton Woods System in 1973, the international financial system opted largely for the flexible exchange rate system. Along with this world has witnessed an increasing degree of volatility. When a particular currency depreciates vis-à-vis US dollar, then the prices of traded goods denominated in the depreciation currency will increase.
Suppose the depreciating currency is the Indian rupee and the international reference currency is the US dollar. As the rupee depreciates, the prices of imported goods in the Indian domestic market should increase. Suppose the rupee depreciates by 10 per cent in a given period other things remaining the same, the prices of imported goods should rise by 10 per cent approximately. But in reality the traders may not pass on the full impact of price change due to the depreciation. This is the pass-through puzzle, as exchange rate destination currency prices of the internationally traded goods. Suppose in our taken example the prices of the imported goods increase by 70 per cent then in this case the pass-through is 70 per cent.
The idea of pass-through has two connotations: (i) the pricing of destination on currency closely follows the procedure of imperfect competition; and (ii) the asymmetry of price change relative to the change in the exchange rate is connected to the concept of elasticity consideration in international trade. The elasticity approach used in the explanation of change of trade assumes that pass-through is complete and so the effects of price change on demand or supply can be studied. If exchange rate changes are not reflected in the selling prices of the traded commodities, the expected quantity adjustment will be retarded even when the price elasticity is sufficiently large. Thus the degree of pass-through can effectively influence the channels of the elasticity operations. This has another implication. If there exists a significant lag in the transmission of exchange rate changes to the prices, and also there are lags in price- quantity change operations, then the efforts of adjustment in the balance of trade through the change in the exchange rate may be severely affected. Thus pass-through deals with this international transmission mechanism.
The inadequate response in the change of destination prices resultant to the exchange rate changes is linked to the existence of imperfect competition. Here the structure of the market is important. For the explanation of the role of the market structure in determining the pass-through relationship, it is useful to start with a competitive market with imported goods which are perfect substitutes of domestically produced goods. Also, the pricing of the goods will follow the marginal costs, and the elasticity affecting both the demand and supply of the goods response to the change in cost conditions through their reflection in prices.
Under imperfect competition, pricing will not follow the marginal cost rule, and the firms will use mark-up in prices even in a long run situation. So in response to the change in the exchange rate, this mark-up varies which is important. This relates the variation in the profit margin to the degree of pass-through. The sellers think about the maintenance of their market share even at the cost of a squeezed profit margin.
In a paper Dourbusch (1987) has considered the Dixit-Stiglitz (1977) and the Salop (1979) model of competition to capture the effects of imperfect substitutability and product differentiation on price response to the changes in the exchange rates. He concludes that the degree of pass-through is directly related to the degree of substitution between the imported goods and domestic produced goods. Using the cases of firms as Bertrand competitors, Fischer (1989) finds that in a segmented market with limited arbitrage an appreciation of the domestic currency will lead to a higher pass-through if the domestic market is monopolistic relative to the foreign market.
Two things are important in the market structure: the degree of substitution between goods and domestically produced goods and the nature of segmentation of the market. The studies in the literature regarding the extent of pass-through [Isard (1977), Kravis and Lipsey (1978), Richardson (1978), Ohno (1989), Knetter (1989, Marston (1990) and Kasa (1992)] generally support the view that there are significant differences in the pricing behaviour of firms in response to exchange rate changes, as a result of less than perfect substitution of goods between imports and domestically produced ones or the presence of segmented markets. Also in an open economy the presence of foreign firms in the domestic market affects the degree of pass-through (Dornbusch, 1987; Sibert, 1992).
The existence of foreign firms in the domestic market leads to the role of multinational corporations (MNC) and intra-firm trade in influencing the degree of pass-through. While the volatility of exchange rates is sometimes extreme, prices in domestic markets cannot swing a lot. Realizing this, MNCs use their subsidiaries in intra-firm pricing to prevent the full transmission of exchange rate changes in domestic prices. In this connection Holmes (1978) finds that the existence of a directly owned sales subsidiary is a helpful factor in enabling the firm to fix prices in such a way that it creates minimum effects in the market. These sorts of practices have been corroborated by Dunn (1970) also in the case of Canada.
One standard practice of the MNCs is that they use internal of intra-corporate exchange rates in the case of intra-firm transactions. The latter type of transactions generally occur between a parent firm and its wholly-owned subsidiaries, or majority-owned affiliate or between two subsidiary firms. The intra-corporate exchange rate may deviate significantly from the true one for a long period, as this is used as a clearing mechanism for intra-firm trade. The MNCs use this sort of pricing mechanism to optimize profit in their global operations (Helleiner, 1985).