Heterogeneity of exchange rate pass-through, intermediate goods trade and China’s monetary policy

SHI Feng1,2 WANG Chan3 GONG Liutang1,2

(1.Guanghua School of Management, Peking University)
(2.Key Laboratory of Mathematical Economics and Quantitative Finance (Peking University) under the Ministry of Education of China)
(3.School of Finance, Central University of Finance and Economics)

【Abstract】China plays an important role in international trade of intermediate goods and final consumption goods, with different degrees of exchange rate pass-through into these two categories of goods. We introduce the intermediate goods trade and incomplete exchange rate pass-through into an otherwise standard open economy model,and investigate their implications for monetary policy. In the benchmark model, the degree of exchange rate pass-through to imported intermediate goods contributes to volatility of the intermediate goods output gap and consumer goods’ PPI in domestic economy, while the degree of exchange rate pass-through to imported consumer goods leads to movements of both the consumer goods output gap and intermediate goods’ PPI in domestic economy. The volatility of domestic consumer goods is the crucial ingredient that determines the social welfare consequence, because of their high price stickiness. As a result, the effect of the incomplete exchange rate pass-through to intermediate goods on social welfare is significant. Sensitivity analysis reveals that welfare performance significantly depends on the relative degree of incomplete exchange rate pass-through to the imported intermediate goods and consumer goods. If the degree of exchange rate pass-through to imported intermediate goods is lower compared with consumer goods, the optimal choice is to stabilize the PPI in the domestic consumer goods sector and vice versa.

【Keywords】 incomplete exchange rate pass-through; intermediate goods trade; Bayesian estimation; Taylor rule; welfare analysis ;

【Funds】 Young Teachers Fund of Central University of Finance and Economics (QJJ1707) New Teachers Science Research Fund of the School of Finance of Central University of Finance and Economics

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    Footnote

    [1]. ① For empirical studies on trade in intermediate goods, see Bridgman (2012), Feenstra (1998), Hummels et al. (2001), Johnson (2014) and Yi (2010).

    [2]. ② For detailed analysis, see Engel (2003), Campa and Goldberg (2005), Choudhri and Hakura (2006), and Bouakez and Rebei (2008). Liu et al. (2008) and Cao et al. (2012) discussed the incomplete pass-through effect of RMB exchange rate. Shi and Fu (2010) and Cao (2016) reviewed and summarized the literature on incomplete exchange rate pass-through.

    [3]. ③ Flexible price allocation refers to the allocation of resources when prices of all the manufacturers are completely flexible. The value of an economic variable under flexible price allocation is also called the natural rate level.

    [4]. ④ Pricing to market is also called local currency pricing (LCP). When this pricing method is adopted, the manufacturer selects both the local currency and foreign currency prices of the goods, and the foreign currency prices of the goods are completely unaffected by exchange rate fluctuations. This is an extreme case of incomplete exchange rate pass-through, namely no exchange rate pass-through at all. In contrast, in producer currency pricing, manufacturers only choose the price denominated in their home country’s currency, the price of goods denominated in the foreign currency is jointly determined by the price denominated in the local currency and the nominal exchange rate, and the exchange rate pass-through is complete.

    [5]. ⑤ In the steady state, the purchasing power parity theory is tenable, and the relative consumption of the two countries’ households depends entirely on the real exchange rate. In LCP, the consumer price indices of the two countries are not affected by exchange rate fluctuations and exogenous shocks. If floating exchange rates are adopted, the real exchange rates of the two countries will deviate from the natural rate levels, which will reduce social welfare.

    [6]. ① In a two-sector closed economy, Aoki (2001) finds that when price stickiness exists in one sector and prices in the other sector are completely flexible, the central bank can realize Pareto optimal allocation only by completely stabilizing the PPI of the sector with price stickiness.

    [7]. ② In open economy, domestic households buy domestic and foreign consumer goods at the same time. CPI is the sum of the constant elasticities of substitution of consumer goods’ PPI in the two countries, with prices denominated in the domestic currency.

    [8]. ① After China’s entry into the WTO, trade in intermediate goods has become an important part of China’s foreign trade. However, there are differences in the proportion of intermediate goods between import and export trade. The proportion of intermediate goods import in the total import trade has been maintained above 70% (2000–2015), which reached a peak in 2007 (over 80%), while the proportion of intermediate goods export in the total export trade has been around 50% (Peng and Zhang, 2017). Therefore, this paper pays more attention to the incomplete exchange rate pass-through into imported intermediate goods and consumer goods.

    [9].

    [10]. ② Because there are intermediate goods manufacturers, consumer goods manufacturers and retailers of foreign consumer goods and intermediate goods in the home country, the dividends received by households in each period are the sum of the monopoly profits of the above four types of firms.

    [11]. ③ Due to the space limitation, the log-linearization results of the equilibrium conditions are directly presented without the deduction process of the model and technical details, which are available upon request.

    [12]. ① The lowercase letter xt represent the deviation of the logarithm of economic variable Xt from the logarithm of its deterministic steady-state value , namely . The deterministic steady-state value refers to the value of a relevant economic variable when the model does not include price stickiness and is unaffected by any exogenous shock. This paper uses the method of Uhlig (1999) for log-linearization.

    [13]. ② φjt represents the gap in the law of one price in sector j, with φjt = st + pFjt* − pFjt and j ∈ {i, f}. Here, i represents the sector of imported intermediate goods, j represents the sector of imported consumer goods, pFjt* is the price of the imports of sector j in the foreign currency, and pFjt is the retail price of the imports of sector j in the home country.

    [14]. ③ In order to emphasize the impact of incomplete exchange rate pass-through on domestic monetary policy, this paper simplifies the foreign economy. The prices of the two types of manufacturers in the foreign country are completely flexible, so domestic retailers of imports in the same sector face the same wholesale prices StPFft* and StPFit*. After cost-free differentiation and Calvo price adjustment, the domestic retail prices PFft (hf*) and PFit(hi*) of import retailers are obtained. In this paper, PKjt and PKjt* respectively represent the domestic currency price and foreign currency price of the goods of sector j in country K country at time t. The wholesale price of the two sectors’ import retailers is the exchange rate-adjusted price StPFjt* in the domestic currency when the law of one price is tenable. When the domestic retail price corresponds to the maximum profit, the retailers choose the price PFjt (hj*).

    [15]. ① It should be noted that in the mechanism of Calvo (1983), all manufacturers adjust the price according to a certain probability, and the manufacturers with price adjustment in period t need to consider the situation that they cannot adjust the price in period t+k. Therefore, PFj, t+k | t represents the price of the manufacturer in period t+k who adjusts the price in period t, and PFj, t+k represents the social average price of j type of imports in period t+k.

    [16]. ① In particular, θj* represents the proportion of j type of retailers that cannot adjust price in the period, and θj represents the price stickiness of manufacturers in sector j of the home country.

    [17]. ② This paper uses to represent the deviation of variable Xt from the natural rate level Xtz, with , which is also called the gap. Here, the natural rate level is the value of a variable when no manufacturer has price stickiness.

    [18]. ③ is the sum of the CES of the differentiated intermediate goods of the home country, and εi is the substitution elasticity of the differentiated intermediate goods of the home country.

    [19]. ① Since the benchmark model in this paper includes intermediate goods trade, the GDP of the home country includes the output of the home country’s consumer goods and the net export of intermediate goods.

    [20]. ② Among the literature on China’s open economy, in Jin and Hong (2015), the household subjective discount factor is 0.9725 after calibration based on the seven-day inter-bank pledged repo rate. However, its difference with the value in this paper does not affect the transmission mechanism discussed in this paper and the conclusion of this paper.

    [21]. ① According to the settings of Smets and Wouters (2007), Chen and Gong (2006), Adolfson et al. (2007), Lubik and Schorfheide (2007) and Jin and Hong (2015), this paper chooses the prior distributions of the model’s structural parameters. Zhuang et al. (2016) examined three kinds of monetary policy rules and found that parameter uncertainty only affected the size of the shock effect and did not cause directional change.

    [22]. ① The data processing and the selection of prior distributions are not reported here, which are available upon request.

    [23]. ② Due to the space limitation, the specific deduction process of the welfare function is not reported here, which is available upon request.

    [24]. ① For detailed definitions of Economy I to Economy IV, see the part of parameter estimation.

    [25]. ② Due to the space limitation, the specific deduction process of the welfare function is not reported here, which is available upon request.

    [26]. ① The reasons why this paper follows Gong et al. (2016) and chooses the same three types of Taylor rules are as follows. (1) There are also intermediate goods trade and different price indices in this paper, including CPI, intermediate goods’ PPI and consumer goods’ PPI, so it is necessary to consider Taylor rules that stabilize different price indices and their impacts on social welfare. (2) This paper introduces the heterogeneity of exchange rate pass-through for intermediate goods and consumer goods, and adopts the same monetary policy rules, which can help highlight the impact of exchange rate pass-through heterogeneity on the optimal monetary policy.

    [27]. ① This is because exchange rate fluctuations will affect the domestic currency prices of foreign consumer goods and the domestic CPI (Gali and Monacelli, 2005).

    [28]. ② In the new Keynesian economics, in order to avoid uncertainty, it is necessary to assume δπ > 1, and δy is usually smaller than 1.

    [29]. ③ When analyzing the relationship between the heterogeneity of exchange rate pass-through and Taylor rule, we set δπ = 1.5 and δy = 0.125.

    [30]. ① Firstly, we carry out log-linearization for the equilibrium condition of the model and obtain a linear equation system. Secondly, we adopt the method of Uhlig (1999), and obtain the transition function and policy function of the economic system. In the transition function, the current-period state variable is expressed as a function of the previous-period state variable and the current-period exogenous shock. In the policy function, the control variable is expressed as a function of the previous-period state variable and the current-period exogenous shock. Finally, given the standard deviation of exogenous shock, the fluctuation rate of the state variable is obtained according to the transition function, and then the fluctuation rate of the control variable is obtained according to the policy function.

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This Article

ISSN:1002-9621

CN: 11-1138/F

Vol 41, No. 07, Pages 25-48

July 2018

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Article Outline

Abstract

  • 1 Introduction and literature review
  • 2 Open economy model
  • 3 Parameter estimation
  • 4 Numerical simulation
  • 5 Conclusion
  • Footnote

    References