Exchange rate pass-through in a competitive model of pricing-to-market

This paper extends the Mussa and Rosen (1978) model of quality-pricing under perfect competition. Exporters sell goods of different qualities to consumers who have heterogeneous preferences for quality. Production is subject to decreasing returns to scale and, therefore, supply and the toughness of competition react to cost changes brought about by exchange rate fluctuations. First, we predict that exchange rate shocks are imperfectly passed through into prices. Second, prices of low quality goods are more sensitive to exchange rate shocks than prices of high quality goods. Third, in response to an exchange rate appreciation, the composition of exports shifts towards higher quality and more expensive goods.> ; We test these predictions using highly disaggregated price and quantity U.S. import data. We find evidence that in response to an exchange rate appreciation, the composition of exports shifts towards high unit price goods. Therefore, exchange rate passthrough rates that are measured using aggregate data will tend to overstate the actual extent of pass-through.