NBER WORKING PAPER SERIES DISTRIBUTION MARGINS, IMPORTED INPUTS, AND THE SENSITIVITY OF THE CPI TO EXCHANGE RATES. José Manuel Campa Linda S.

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1 NBER WORKING PAPER SERIES DISTRIBUTION MARGINS, IMPORTED INPUTS, AND THE SENSITIVITY OF THE CPI TO EXCHANGE RATES José Manul Campa Linda S. Goldbrg Working Papr NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachustts Avnu Cambridg, MA March 2006 Th viws xprssd in this papr ar thos of th individual authors and do not ncssarily rflct th position of th Fdral Rsrv Bank of Nw York or th Fdral Rsrv Systm. W bnfittd from th commnts of Jannin Baillau, Charls Engl, Luca Ddola, Josph Gagnon, Rbcca Hllrstin, Srgio Rblo, Stphani Schmidt-Groh, Cdric Till and participants in th Jun 2003 Rom Workshop and th Bank of Canada-ECB confrnc on Exchang Rats, Dcmbr W thank Luis Gonzalz for xcptional rsarch assistanc, and also acknowldg th work of María Olaga and Isabl Paul. Nadim Ahmad of th OECD patintly answrd our many data qustions and th Fundación Ramón Arcs for financial support. Addrss corrspondncs to Linda S. Goldbrg, Fdral Rsrv Bank of NY, Rsarch Dpartmnt, 33 Librty St, Nw York, N.Y Tl: ; fax: ; mail: Linda.Goldbrg@ny.frb.org. Th viws xprssd hrin ar thos of th author(s) and do not ncssarily rflct th viws of th National Burau of Economic Rsarch by José Manul Campa and Linda S. Goldbrg. All rights rsrvd. Short sctions of txt, not to xcd two paragraphs, may b quotd without xplicit prmission providd that full crdit, including notic, is givn to th sourc.

2 Distribution Margins, Importd Inputs, and th Snsitivity of th CPI to Exchang Rats José Manul Campa and Linda S. Goldbrg NBER Working Papr No March 2006 JEL No. F3, F4 ABSTRACT Bordr prics of tradd goods ar highly snsitiv to xchang rats, but th CPI, and th rtail prics of ths goods, ar mor stabl. Our papr dcomposs th sourcs of this stability for twnty-on OECD countris, focusing on th important rols of distribution margins and importd inputs in transmitting xchang rat fluctuations into consumption prics. W provid rich cross-country and cross-industry dtails on distribution margins and thir snsitivity to xchang rats, importd inputs usd in diffrnt catgoris of consumption goods, and wights in consumption of nontradabls, hom tradabls and importd goods. Whil distribution margins damp th snsitivity of consumption prics of tradabl goods to xchang rats, thy also lad to nhancd pass through whn nontradd goods prics ar snsitiv to xchang rats. Such pric snsitivity ariss bcaus importd inputs ar usd in production of hom nontradabls. Calibration xrciss show that, at undr 5 prcnt, th Unitd Stats has th lowst xpctd CPI snsitivity to xchang rats of allcountris xamind. On avrag, calibratd xchang rat pass through into CPIs is xpctd to b closr to 15 prcnt. Linda S. Goldbrg Fdral Rsrv Bank of NY Rsarch Dpartmnt 33 Librty Strt Nw York, NY and NBER linda.goldbrg@ny.frb.org José Manul Campa IESE Camino dl Crro dl Aguila Madrid SPAIN jcampa@is.du

3 1. Introduction An unxpctdly small dgr of consumr pric indx (CPI) rsponsivnss to import pric and xchang rat fluctuations has bn posd as a puzzl in mpirical intrnational macroconomics. Rsarchrs hav argud that this gap may b xplaind in a comptitiv stting partly by th prsnc of nontradabls goods in consumption and partly by th xistnc of a distribution sctor which rducs th forign contnt within imports, driving a wdg btwn bordr and rtail prics (Burstin, Nvs, and Rblo 2003). 1 Expnditurs on transportation, storag, financ, insuranc, wholsaling, and rtailing add local-valu-addd componnts to th final consumption valu of imports and rduc th wight on bordr prics for imports pr s in consumr pric indics. An altrnativ xplanation ariss from th prsnc of imprfct comptition in th distribution sctor. Doubl marginalization occurs whn distributors absorb som of th xchang-rat fluctuations in ordr to maintain stabl prics or xpand markt shar at th rtail lvl (Hllrstin 2004). Thus, distributor profit margins also can provid partial insulation from intrnationally transmittd shocks. A complmntary xplanation, offrd by Bacchtta and van Wincoop (2003), is that consumr pric insnsitivity to xchang rats may b gnratd as an optimal pass through stratgy in a modl of forign xporting firms slling intrmdiat goods to domstic producrs who compt with nontradd goods producrs. 2 Rgardlss of th strngth of snsitivity of bordr prics to xchang rats, if rtailrs absorb xchang rat fluctuations in thir own margins, thn consumrs will xprinc lss pass through than prics at th bordr (Dvrux, Engl, and Till 1999, and Dvrux and Engl 2002). W xplor th phnomnon of low CPI rsponsivnss to xchang rats by carfully framing what CPI snsitivity to xchang rats is xpctd to b, givn th xistnc of hom and forign tradabl goods and nontradabl goods in consumption, and givn th potntial rols of distribution margins and importd inputs to production. Ths faturs ar important for propr idntification of th forign vrsus local componnts xposd most xtnsivly to xchang rat movmnts. W fram our contribution, which is primarily mpirical, within a 1 Campa and Goldbrg (2005) and Campa, Goldbrg, and Gonzalz-Minguz (forthcoming 2006) dtail th pass through rats on import prics of OECD and uro-ara countris. Frankl, Parsly, and Wi (2004) also documnt pass through lasticitis for dvloping countris. 2 Corstti and Ddola (2005) mak rlatd argumnts in a diffrnt production chain and pricing st-up. 1

4 workhors two country modl with wag stickinss. Mthodologically, w introduc a straightforward variant of Obstfld and Rogoff (2000), Corstti and Ddola (2003), and Burstin, Nvs, and Rblo (2003). W xplicitly introduc distribution margins, a snsitivity of ths margins to xchang rats, and rols for importd inputs in th production of tradabl and nontradabl goods. Th modl provids a clar dlination of th dtrminants of th pric lasticitis of spcific consumr goods and shows how ths lasticitis aggrgat to yild CPI snsitivity. Consumr prics could b insnsitiv to xchang rats bcaus a small shar of th goods composing th CPI baskt hav xposur to xchang rat changs via tradabl products, or bcaus th comptitiv structur or th siz and bhavior of th distribution sctor isolats final prics from xchang rat movmnts. Th ral contribution of this papr is its mpirical analysis, whr w carfully apply ths concpts to data from twnty-on OECD countris. 3 Most significantly, w documnt th siz of th distribution sctor and th dgr of importd input us by country, by industry, and in som cass ovr tim, and xplor thir rspctiv rols in th pass through disconnct. Sinc CPI discussions rquir margins applid on consumption goods pr s, and not th typically lowr margins on govrnmnt and invstmnt goods, w carfully sparat out th margins by sourcs of final dmand. Across this sampl of countris, distribution margins on houshold consumption ar btwn 30 and 50 prcnt of purchasrs prics. Ths margins ar dominatd by wholsal and rtail sctor costs, with transportation and storag costs rlativly low xcpt in th cas of various raw matrials and mining industris. W us ths data to xplor th xistnc of doubl marginalization, whrin local wholsalrs and rtailrs adjust thir margins in rspons to xchang rat fluctuations. Whil our data can only giv crud indications of margin adjustmnt, th availabl tim-sris vidnc for ight countris supports th hypothsis that distribution margins ar snsitiv to xchang rats. Distribution margins fall whn th local currncy dprciats and imports bcom mor xpnsiv in local currncy trms. W furthr documnt th rol of importd inputs across countris and across both tradabl and nontradabl goods production. In tradabl goods production, importd inputs account for btwn 10 and 48 prcnt of th final pric. Importd inputs ar also usd lss 2

5 xtnsivly in th production of nontradabls, ranging from 3 prcnt in th Unitd Stats to 22 prcnt in Hungary. Pulling togthr ths mpirical findings, w calibrat th snsitivity of country consumr pric indics to xchang rats. Using data on th shars of imports in tradabls consumption, th shars of tradabls in ovrall consumption, th importd input us across sctors, and th distribution margins and thir rsponsivnss, w compar calibratd snsitivitis of various pric indics and th CPI. Not surprisingly, thr is considrabl cross-country htrognity in ths prdictions. It is also notworthy that th calibratd CPI snsitivitis to xchang rats ar not systmatically diffrnt from obsrvd CPI snsitivity to xchang rats. It is not unusual for this snsitivity to b low, oftn blow 10 prcnt of any xchang rat chang. W mphasiz that th rats of xchang rat pass-through into CPIs dpnd on th rol that tradabls goods hav in th conomy both tradabls in consumption, and importd inputs in production of nontradd and hom tradabl goods. W provid substantial mpirical vidnc showing th xtnt to which distribution margins ar important for damping bordr pric pass through into consumption prics, as strssd in rcnt thortical contributions to this litratur. W also mphasiz, howvr, that th xistnc of ths margins is also an addd conduit for xchang rat ffcts. Distribution xpnditurs for all tradabl goods consumd ar snsitiv to xchang rats to th xtnt that th nontradabl sctor rlis on importd productiv inputs. Importd inputs mattr both for th prics of dirctly consumd nontradabl goods and for tradabl goods in th final consumption baskts of most dvlopd conomis. Sction II bgins our xposition by documnting th xtnt of th pass through of xchang rats into import pric and CPI across countris. W thn prsnt a modl of pass through into rspctiv pric indics, accounting for th rols of distribution and importd inputs. Sction III prsnts vidnc on distribution margins, importd inputs, and rlvant trad shars across countris, industris, and tim. Sction IV gnrats prdictd valus for pass through into th altrnativ pric sris of ach country, and compars prdictd and obsrvd pass through. Sction V concluds. 3 This vidnc complmnts and considrably xtnds th vidnc on Argntina and th Unitd Stats providd by 3

6 II. Pric Elasticitis with Rspct to Exchang Rats Tabl 1 rports stimatd pass-through rats into import prics and consumr pric indxs for twnty-thr OECD countris. Th rportd cofficints ar th stimatd passthrough rats from a rgrssion of changs in import prics and consumr prics on changs in nominal xchang rats and forign prics using quartrly data for th priod 1975:1 to 2003:4. Th rportd stimats of pass through of xchang rat changs ar th cumulativ on-yar impact from an xchang rat shock stimatd from a partial-adjustmnt modl. Th ffcts on import prics ar providd in th first data column. Th nxt data column prsnts similar passthrough lasticitis for consumr pric indics. 4 Th diffrncs btwn th import pric and th CPI rsponsivnss to xchang rat movmnts across almost all OECD countris ar striking. Pass through into bordr prics far xcds pass through into th CPI. Whil striking, ths diffrncs in snsitivity ar not ncssarily surprising, motivating th xtnsiv analysis of our papr. For ths OECD countris, th (unwightd) avrag pass through lasticity is 0.64 for import prics. For svntn of th twnty-thr countris prsntd in th tabl, xchang rat pass-through into import prics is statistically diffrnt from zro. This finding rjcts th hypothsis that import prics in domstic currncy do not adjust to xchang rat changs. Campa and Goldbrg (2005) cam to similar conclusions for both short-run and long-run passthrough rats in th OECD countris, as did Campa, Goldbrg, and Gonzálz-Minguz (2006) for th uro-ara countris. Typically, most of th pass through of xchang rats into import prics occurs within on or two quartrs aftr an xchang rat movmnt. 5 Burstin, Eichnbaum and Rblo (2002). 4 Th stimation tchniqu is basd on Campa and Goldbrg (2005) and providd in th tchnical appndix. This analysis is basd on linar rgrssion modls, without cointgrating rlationships modld. S rlatd discussion in th aformntiond papr, and in Campa, Goldbrg, and Gonzalz (2006). VAR stimats ar prsntd in th appndix, and vrify th rportd rsults. 5 Th rgrssions ovr full sampl data for Blgium and Franc, starting in 1975, support long-run pass-through lasticitis in xcss of on. Ths lasticitis implausibly imply that pass through is mor than complt, instad of boundd by on. Both Blgium and Franc xprinc similar shar and prsistnt acclrations in import prics btwn 1979 and 1985, with import prics mor than doubling in this priod. Currncy dprciations during this priod wr not strongly trnding, and wr mild. If th stimation intrval instad bgins with 1987 data th 4

7 Tabl 1: Exchang Rat Pass-through Elasticitis into Import and Consumr Pric Indics Country Pass-Through on Import Prics Pass-through on Consumr Prics Australia 0.67* Austria Blgium Canada 0.65* Czch Rpublic 0.6* 0.60*+ Dnmark 0.82* 0.16*+ Finland Franc 0.98* 0.48*+ Grmany 0.80* Hungary 0.78* 0.42*+ Irland Italy Japan 1.13* 0.11*+ Nthrlands 0.84* 0.38*+ Nw Zaland *+ Norway 0.63* Poland 0.78* 0.59*+ Portugal 1.08* 0.60*+ Spain 0.70* 0.36*+ Swdn 0.38* Switzrland 0.93* 0.17*+ Unitd Kingdom 0.46* Unitd Stats 0.42* Avrag * (+) indicats xchang rat pass through significantly diffrnt from zro (on) at a 5 prcnt confidnc lvl. Most data ar quartrly, spanning 1975 through arly Data sourcs: nominal xchang rat and consumr prics com from th IFS; import pric coms from th OECD. Spcific start and nd dats by country ar dtaild in th data appndix. Long-run lasticitis (four quartrs) shown. By contrast, avrag pass-through into consumr prics is 0.17 ovr th long run, with much largr standard dviations. Ths avrags mask hug cross-country diffrncs in CPI snsitivity. Nvrthlss, th hypothsis that th pass through to CPIs is smallr than on can b rjctd for all but on country, Austria, and in Austria s cas th insignificant point stimat is ngativ. In gnral, largr countris tnd to hav lowr lvls of stimatd pass through into th stimatd pass through rats for Franc ar similar to thos for th rst of Europ. Pass through rats for Blgium 5

8 CPI during this priod, oftn blow 10 prcnt, whil stimatd lasticitis for som countris can b as larg as 60 prcnt (Czch Rpublic, Poland, and Portugal). 6 Th diffrncs btwn th stimatd import pric and CPI snsitivitis ar larg, positiv, and vary xtnsivly across countris. A. A Two Country Modl of th Exchang Rat Pass Through For formalizing th xchang rat disconnct w appal to a workhors two-country modl with wag stickinss, as in Obstfld and Rogoff (2000) and Corstti and Ddola (2003). This approach has a utility-basd framwork that xplicitly tracks th dgr of substitutability of importd and domstic products, and prsnts th xplicit cost functions facd by producrs. W assum C.E.S. utility functions ovr nontradd and tradd goods consumption. Both sctors produc a continuum of varitis with similar lasticitis of substitution, θ. Hom (h) and forign (f) tradabl goods consumption ar imprfct substituts, with an lasticity of substitution of φ T > 1. Consumption of tradabl (T) and nontradabl (N) products ar also govrnd by a constant lasticity of substitution φ. Givn th C.E.S. structur of dmand, and undr th standard assumption that ach varity is sufficintly small so that changs in th prics of on varity hav no impact on th pric aggrgators, only comptition among brands mattrs. Th first ordr condition facd by a producr of a brand h is: θ pt ( h) = ct ( h) θ 1 (1) whr c t (h) is th marginal cost of production and dlivry to consumrs of brand h. Th marginal cost of production at th producr lvl is dtrmind by rlativ productivity lvls and nominal wags, which ar assumd to b fixd in th short run and xognous to xchang rat changs. This spcification implis that producr currncy prics hav a constant markup of prics ovr marginal costs. dclin significantly, but rmain high. Du to a short availabl data sampl w prclud Grc from this tabl. 6 Frankl, Parsly and Wi (2004) provid an xtnsiv analysis of pass through around th world, importantly including th dvloping countris, but for a smallr group of products than covrd by th import pric aggrgats of ths industrializd countris. 6

9 On th supply sid, th marginal cost of production includs two componnts of cost: th cost of producing th good and th cost of dlivry of ach brand to th consumr. Following Ercg and Lvin (1995), Burstin, Nvs and Rblo (2003), and Corstti and Ddola (2003) w assum that bringing on unit of tradd goods to consumrs rquirs units of a baskt of diffrntiatd nontradd goods indxd by n. 7 For computational simplicity, no distinction is mad in ths modls btwn nontradabl consumption goods which dirctly ntr an agnt s utility, and nontradd distribution srvics which ar jointly consumd with tradd products. In mpirical analyss, distribution costs includ xpnditurs on wholsal and rtail sctor srvics, as wll as xpnditurs on transportation and storag. Lt Pt ( h) dnot th pric of brand h at producr lvl. With a comptitiv distribution sctor, th consumr pric of good h is simply ( ) ( ) P ( h) = P ( h) + m h P n (2) t t t t whr Pt ( n ) is th corrsponding utility-basd pric indx for nontradabl products and mt ( ) h ar th distribution srvic inputs rquird pr unit of output. This spcification attributs th failur of purchasing powr parity across countris, at last in part, to th prsnc of local transaction and distribution costs, as argud by Obstfld and Rogoff (2000). Distribution margins ar dirct contributors to th purchasr prics Pt ( h ). Analogous notation is usd for th importd goods sctor, indxd by brand f. W introduc two simpl xtnsions to this workhors modl to gnrat additional ralism in pric snsitivity to xchang rats. First, w allow for th us of importd productiv inputs, thrby introducing a dirct channl through which xchang rat changs influnc producr marginal costs 8. W suppos that pr unit production rquirs importd input shar µ ( h) on hom tradabl goods and ( n) t µ on hom nontradabl goods. Th pricing quations for t 7 It is assumd that θ θ 1 θ 1 θ 1 m = m( n) dn 0 diffrncs in distribution margins ar not xplicitly modld.. All tradd goods us th sam distribution inputs, so that sctoral 7

10 hom nontradabl goods n, hom tradabl goods h, and importd consumption goods f ar givn by θ θ Wt W * t Pt ( n) = ct ( n) = + µ t ( n : ) (3) θ 1 θ 1 Z Z N θ θ Wt W * Pt ( h) = ct ( h) = + mt ( h : ) Pt ( n) + µ t ( h : ) (4) θ 1 θ 1 Z Z * t t = t t = + t ( ) t θ 1 θ 1 ZF H θ θ W P ( f ) c *( f ) m f : P ( n) (5) F whr W t rfrs to th wag pr unit of labor at hom, W t * rfrs to forign wags, and th Z trms rfr to productivity in th hom tradabls (h), hom nontradabls (n), and forign tradabls (f). This drivation assums that all distribution costs ar incurrd in th hom markt, and productivity paramtrs as wll as domstic and forign wags ar sticky ovr th rlvant pricing horizon., th xchang rat, is th domstic currncy pric of forign xchang. 9 This widly usd basic framwork, assums sticky wags, xognous productivity, and a monopolistic comptition st-up that gnrats th mark-up rul ovr costs notd abov. Th ida of local contnt in th final consumption of importd goods is found in various forms lswhr. Most, xplicitly, trms lik m P ( n) ar found in Corstti and ddola (2003) and Burstin, t t Nvs and Rblo (2003) whr distribution costs driv a wdg btwn bordr and consumption prics on imports. Othr studis considr imports mor as intrmdiat goods that ar r-pricd or combind with local contnt by distributors (or hom final goods producrs). Dvrux, Engl, and Till (1999) and Dvrux and Engl (2002) gav th distributor powr to r-pric importd goods, rsulting in importd goods prics that wr sticky in th consumr s currncy and consistnt with prvalnt local currncy pricing. Obstfld and Rogoff (2000) had final consumption goods gnratd whn tradd goods wr tratd as intrmdiat goods, without r-pricing, so that producr currncy pricing was mor prvalnt. Bacchtta and van F 8 Th assumd short run rigidity of wags to ral xchang rats is supportd by rcnt mpirical analyss [Campa and Goldbrg 2002, Goldbrg and Tracy 2003], xcpt prhaps for som of th lss-skilld workrs changing jobs. Som sctoral diffrncs in wag lasticitis ar vidnt in U.S. data. 9 This spcification, which follows Corstti and Ddola, implis that th markup on th final pric gts also chargd by th producr on th distribution part of th costs. An altrnativ approach could dlink th markups on th producr and distribution costs. Our drivation disrgards th scond-ordr ffct of nontradabls sctor us of importd inputs in th costs of th hom tradabls and in th distribution costs of th importd goods. 8

11 Wincoop s (2003) modl nabls distributors to choos a pricing structur that minimizs rlativ pric fluctuations on th importd good. By contrast, Burstin, Nvs, and Rblo (2003), following Ercg and Lvin (1945), implicitly assum prfct comptition among distributors, who cannot thrfor adjust th siz of margins chargd to dlivr ach brand to th consumr. Undr this assumption, th distribution sctor drivs a wdg btwn bordr pric and consumption pric snsitivity to xchang rats, but dos not hav a rol byond bing an input into final consumption. In our spcification of distribution costs in quations (4) and (5) w introduc th xchang rat as an argumnt of th distributor margin mt ( i : ) whr i ( h, f ). Including this rlationship allows for possibl dviations in th mpirical analysis from th comptitiv distribution sctor assumd in quation (2) abov. Our spcification dosn t tak a stand on a particular industrial or comptitiv structur, and instad is intndd to b gnral nough to prmit a fixd distribution margin in th fac of currncy fluctuations or prmit larg margin rsponss if particular assumptions on industrial structur would warrant this. Th procss by which distributors attmpt to activly manag consumr prics is rfrrd to as doubl marginalization, as in Hllrstin (2004). A scond modification w mak to th standard approach is th xistnc of importd inputs as wll as hom inputs into th cost of producing hom tradabl goods. Ths importd input shars, µ ( i : ), i ( n, h), vary by typ of goods, and can b snsitiv to xchang rat t movmnts. This snsitivity could subsum th ffcts of domstic agnts r-pricing importd intrmdiats for local markts and prhaps adding a bit of local contnt. W diffrntiat quations (3) through (5) to driv hom tradabl, hom nontradabl, and importd goods pric lasticitis, or pass through rats, with rspct to xchang rats. w* w* µ t ( n : ) µ t ( n : ) P( n), P( n) / ut ( 1 ( n : ), Z F θ ut ) ( 1 ( n : ), Z F η = = + η = + η ) P( n) / ct ( n) θ 1 Pt ( n) W * µ ( h : ) P( h), P( h) / θ P( n), m( h), m( H : ) P( n) ut ( h: ), Z t F η = = ( η + η ) + ( 1+ η ) P( h) / θ 1 Pt ( h) Pt ( h) (6) (7) 9

12 ( m( f : ) P ( n) ) P( f ) / θ η = = 1 1 η + η P( f ) / θ 1 P( f ) ( ) P( f ), t m( f ), P( n), (8) In quation (6), which assums monopolistic comptition, th ncssary condition for nontradd goods prics to b snsitiv to xchang rats is that producrs us importd inputs. Exchang rat changs pass through fully into th costs of importd inputs, xcpt to th xtnt that th production structur allows substitution away from ths inputs whn thy ar mor µ ( : ), xpnsiv, t n η < 0. Equation (7) shows that hom tradabls prics can rspond to xchang rats through two channls: importd inputs in production or distribution margin rsponss to xchang rat movmnts. Distribution xpnditurs can vary both bcaus nontradabls prics can rspond to xchang rats and bcaus distributors may activly, and prhaps stratgically, adjust thir markups on hom tradabls whn th prics of compting importd brands mov with xchang rats. Exchang rat changs fully pass through into importd input costs, putting upward prssur on final prics xcpt to th xtnt that th hom tradabls producrs can substitut away from th importd inputs. Equation (8) is typically th focal point of studis of th snsitivity of forign goods prics to xchang rats. Not, howvr, that this spcification givs not bordr pric snsitivity, but rathr consumption pric snsitivity to xchang rats. Undr monopolistic comptition, pass through into bordr prics will b complt, xcpt in th prsnc of a distribution sctor. Th distribution sctor damps th import contnt of this consumption good (th first trm), with th magnitud of this damping dpndnt on whthr distributor markups and nontradd goods prics rspond to xchang rats. Th pric lasticity also is smallr whn lasticitis of substitution among goods θ ar largr: producrs charg a smallr markup ovr costs whn th comptitiv nvironmnt is mor intns. As in Corstti and Ddola (2003), productivity conditions play an important rol in dtrmining xchang rat pass through, lading to a stat contingnt componnt of markups, whrby th prics chargd by a producr in diffrnt markts dpnd on asymmtris across countris in rlativ productivity and wags. Th highr th productivity in hom tradabl goods production rlativ to hom nontradabls, th largr th pass through. 10

13 W hav not assumd a spcific functional form for th lasticity of rspons of distribution xpnditurs on hom tradabls and importd goods with rspct to xchang rats. Prsumably, whn th prics of importd goods ris, domstic distributor profits xpand and th sal pric on compting domstic tradabl goods may also ris incrmntally. Pass through of xchang rat fluctuations into import prics should b dampnd whn local distributor margins can adjust in rspons to domstic currncy dprciation. Whil w hav not xplicitly modlld th lasticity of distributor margins, mor structur on this can crtainly b imposd. For xampl, on could tak advantag of diffrncs whn xchang rat fluctuations ar viwd as transitory vrsus prmannt, an intuition arly xpositd by Froot and Klmprr (1989). B. Pass Through into Import Prics, Rlativ to Consumr Prics To driv th gap btwn import pric and CPI rsponsivnss to xchang rats, w bgin with a CES aggrgator Pt P ( T ) φ (1 ) P( n) φ = α + α φ t t, whr ( ) t 1 P T and P t (n) ar pric aggrgators for tradabl and non tradabl products rspctivly, φ is th substitution lasticity and α is th consumption wight. Pass-through of xchang rats into th aggrgat CPI is givn by φ ( ) ( ) 1 1 P T P n = + ( 1 ) φ ( ) ( ) P, t P T, t P n, η α η α η Pt Pt (9) Prics of tradabl goods ar subjct to a similar aggrgator, whr φ Τ is th substitution lasticity and α Τ is th consumption wight. Expanding this xprssion using th tradabl goods aggrgator, th CPI lasticity with rspct to xchang rats is 1 φ 1 T 1 1 T 1 P, PT P φ φ φ φ H PH P T P F PF P N PN η = α αt η + α ( 1 αt ) η + ( 1 α ) η P PT P PT P (10) Aggrgat CPI pass through is a wightd avrag of pass through lasticitis into tradd and nontradd prics. Ths two lasticitis ar stat-contingnt and dpndnt on rlativ wag and productivity paramtrs in domstic and forign markts (i.. unit labor costs), lasticitis of substitution obsrvd btwn tradabl (forign and domstic) and nontradabl goods, importd 11

14 input us in domstic production, and distribution margins. Th CPI lasticity also dpnds on th shar of tradabls in consumption, th shar of importd goods in tradabls, and substitution ( ) ( ) p h, p f, lasticitis btwn products. A highr α magnifis th rol of η and η. A highr α T xpands th rol of p,, h p f η at th xpns of η. Stat dpndnt lasticity is introducd by initial rlativ prics of diffrnt typs of goods in th conomy as and by th rlatd comparisons of unit labor costs across diffrnt typs of goods. Whn φ = φ, quation (8) bcoms T ( ) ( ) ( ) ( ) ( ) ( ) 1 φ 1 φ 1 φ P h P f P n = + ( 1 ) + ( 1 ) P P P P, P h, P f, P n, η α αt η α αt η α η (10) Rul of thumb discussions somtims incorrctly think of th import shar in domstic dmand as th main transmission channl for xchang rats into aggrgat pric indics. If th hom tradabls shar in consumption is zro, such a rul of thumb would focus attntion on th scond trm of quation (10). Howvr, thr ar clarly othr forcs at work that imply diffrnt rsponss of consumption goods to xchang rats. To som dgr, basic pass through dpnds on pric lasticitis, consumption shars, distribution margins, and importd input us. Adjustmnts to this basic masur com about bcaus lasticitis of distribution xpnditurs and importd inputs vary with xchang rats. Bcaus nontradd goods ar consumd dirctly and provid local contnt into both hom tradabl goods and importd goods, this channl can b particularly important for th CPI snsitivity to xchang rats in this modl. This channl disappars only if xchang rat movmnts triggr full substitution away from importd inputs (or if importd input costs ar insnsitiv to xchang rats, as thy ar whn pricd in local currncy). Exchang rats affct hom tradabls prics du to th us of importd inputs in th production of ths goods. Again, only fully inlastic input costs would mak this channl insignificant. Othr channls may impact th CPI through importd goods. Thr is dirct transmission into th CPI through th forign contnt of th consumption good indxd by f, that is, all of th valu of this consumption good lss th xpnditur on distribution costs. Th only modification to this channl occurs if th xpnditur on distribution changs whn th xchang rat movs. This lattr adjustmnt is th doubl marginalization ffct prviously discussd. Finally, thr 12

15 also is a possibility that distributors chang th margins chargd on hom tradabl goods whn thy obsrv compting imports having pric changs attributabl to xchang rats. III. Evidnc on th Distribution Sctor and on Importd Inputs in Production As th prvious drivation shows, xplaining pass through into diffrnt pric masurs rquirs data on distribution margins, dmand lasticitis, importd input us, consumption shars, and rlativ prics within countris. Among ths sris, th vidnc on distribution margins and importd inputs in producton across industris, and across countris ar th last wll documntd. Burstin, Nvs, and Rblo (2003) provid vidnc on th siz of distribution margins using data for two countris, th Unitd Stats and Argntina. Thy conclud that local distribution srvics (xpnditurs on transport, wholsal and rtail srvics, markting, tc.) account for at last half of th rtail prics of consumr goods, and an vn highr shar of tradabl agricultural products. Rauch (1999) found that transportation costs (transport and fright xpnditur as a prcntag of customs valu) for U.S. imports from Japan, or similarly distant countris, in 1970, 1980, and 1990 rangd from 6 to 16 prcnt. Hummls (1999) stimatd avrag trad-wightd fright costs in 1994 at 3.8 prcnt for th Unitd Stats, and 7.5 prcnt for Argntina. Goldbrg and Vrbovn (2001) concludd that local costs account for up to 35 prcnt of th pric of a car. Th vidnc on importd inputs is vn mor limitd. Campa and Goldbrg (1997) provid vidnc for th volution of importd inputs sinc 1975 into manufacturing for th U.S., Canada, Japan and th UK. Hummls, Ishii and Yi (2001) prsnt vidnc in thir work on undrstanding th domstic contnt of a country s xports. Othr vidnc on this falls undr th hading of outsourcing analysis, as xmplifid by work survyd in Fnstra and Hanson (2005). This papr dramitically xpands our mpirical undrstanding of ths two subjcts. W provid vidnc on distribution margins and importd inputs into production for twnty-on countris, brokn down into approximatly thirty industris within ach country and, in som cass, capturd ovr tim. Our masurs ar mor aggrgatd than th micro studis of particular goods production chains, 10 but ar consistnt with thos findings and nabl macro 10 For xampl, Hllrstin (2003) and Goldbrg and Vrbovn (2001). 13

16 analysis of country-wid xchang rat pass through into import prics and th CPI. Th advantag of our masurs is that thy ar consistntly stimatd across countris and hav a rlativly larg dgr of comparability. In a numbr of countris, w ar abl to diffrntiat btwn wholsal and rtail distribution margins and transportation margins. For som countris, w charactriz margin dynamics ovr tim and stimat th rol playd by xchang rat fluctuations in ths dynamics. A.- Data and Masurmnt Issus. W driv information to comput th masurs of importd input and distribution margins from input-output tabls. Thr diffrnt kinds of prics ar usd in Input-Output analyss: basic prics, producr prics, and purchasr s (or final) prics. Basic prics ar th cost of intrmdiat consumption plus cost of basic inputs (labor and capital) plus othr nt taxs linkd to production. Producr prics ar basic prics plus othr nt taxs linkd to products. Purchasr or final prics ar th sum of producr prics and distribution margins (rtail trad plus wholsal trad plus transport costs) plus Valu Addd Taxs. Th diffrnt tax componnts ar twofold: Othr taxs linkd to production ar thos taxs (or subsidis) lvid on companis du to th fact that goods ar producd, but ar not linkd to th amount producd or sold. Othr taxs linkd to products ar thos taxs (or subsidis) lvid on companis that ar linkd to th amount producd or sold. Ths includ VAT tax on th production procss, import dutis, plus othr taxs. Th OECD provids homognous input-output information for a larg sampl of countris. Howvr, w chos not to us th OECD information in this papr. Th OECD inputoutput tabls oftn ar constructd using producrs prics, and thrfor contain pric distortions du to country tax cods. To avoid ths distortions w stimat th distribution margins as th ratio of ths costs rlativ to th valu in purchasrs prics. For this typ of data, w us Eurostat tabls and country sourc data, somtims drawn from so-calld supply-us tabls Ths tabls provid symmtric input-output tabls brokn down by domstic production and imports. Th valu of ach cll in th domstic (or import) tabl rports th amount of inputs consumd from th row industry by th column industry that ar producd domstically (or abroad). W comput th importd input masur as th ratio for ach industry btwn th total 14

17 amount of importd imports to th sum of th total amount of domstically producd and importd inputs. W comput two typs of margins. Our prfrrd margins ar purchasrs prics margins, i.. th xpnditurs on distribution margins plus transportation takn rlativ to total supply valud at purchasrs prics. Our basic prics margins ar similar, xcpt that supply is valud at basic prics. Th masurs constructd using basic prics avoid th issu of diffrnt VAT tax rats, import dutis, tc. across th diffrnt countris. Th margins at purchasrs prics includ nt taxs on production and products. Concptually, th basic margins ar mor similar to supplir calculations, whil th purchasrs margins ar closr to calculations on th basis of consumr prics. Th litratur has traditionally usd margins masurd rlativ to purchasrs prics and, for consistncy, w will focus most of our discussion in this sction on this masur. Th original sourc of th information for th countris for which w comput margins and th yars for which w hav usd country data ar prsntd in Tabl 2. In th last column of Tabl 2 w rport th sourc of th data for ach country. Industry classifications diffr slightly by sourc. W comput margins for ach of th original industris in ach sourc (for xampl 91 in th cas of th Unitd Stats) thn map ths to 58 industry hadings (of which 29 ar manufacturing and primary industris with positiv distribution margins) that w trat as comparabl across countris. 11 W comput ovrall distribution margins and also us th input-output and supply-us tabls of data to dcompos th margins into two componnt parts. For ach industry and ach country, on part of th margin is attributabl to transportation and storag costs, and th othr to wholsalr and rtailr chargs. Th transport margins includ transportation costs paid sparatly by th purchasr and includd in th us of products at purchasrs prics but not includd in th basic prics of a manufacturrs output or in th trad margins of wholsal or rtail tradrs. Th undrlying prmis motivating this split is our xpctation that th componnt of th total distribution margins associatd with wholsalrs and rtailrs ar likly to b most rsponsiv to xchang rat movmnts. Both margin componnts, howvr, would b important for prsistnt dviations in th law of on pric across products and countris. 15

18 Tabl 2: Data Sampl from Input-Output Tabls, by Yar, Country, and Information Typ availabl yars Pric Computation Mthod Sourc Australia 1999/2000 & 2000/2001 Supply, Us and Margins tabl Australian Burau of Statistics Blgium Supply Tabl 1995 & 2000 Us tabl for imports Eurostat Dnmark Supply Tabl 1995 & 2000 Us tabl for imports Eurostat Estonia 1997 Supply Tabl 1997 Us tabl for imports Eurostat Finland Supply Tabl 1995 & 2000 Us tabl for imports Eurostat Franc 1995,1997, Supply Tabl Eurostat 2000 Grmany 1995 & & 2000 Us tabl for imports Supply Tabl Us tabl for imports Eurostat Grc 1998 Supply Tabl 1998 Us tabl for imports Eurostat Hungary Supply Tabl 2000 Us tabl for imports Eurostat Irland 1998 Supply Tabl 1998 Us tabl for imports Eurostat Italy Supply Tabl 1995 & 2000 Us tabl for imports Eurostat Nthrlands Supply Tabl Us tabl for imports Eurostat Nw Zaland 1996 Supply, us, and import tabls Statistics Nw Zaland Norway Poland Portugal Spain , 1995 Swdn Unitd Kingdom Unitd Stats Supply Tabl Us tabl for imports Input output tabl Us tabl for imports Supply Tabl Us tabl for imports Supply Tabl Us tabl for imports Supply Tabl Us tabl for imports Supply Tabl Us tabl for imports Annual I-O Accounts Bnchmark I-O tabl Eurostat Eurostat Eurostat Eurostat Eurostat Eurostat Burau of Economic Analysis 11 This harmonization and th industry dfinitions ar not xact across countris, but w nonthlss trat ths as matchd in our spcific mpirical discussions. 16

19 B. Th Siz of Country and Industry Distribution Margins W masur distribution margins for 29 manufacturing and primary-industry groupings. Th rang of valus for th distribution margins across countris and for ths 29 industris (unwightd by country or industry siz) ar providd in Tabl 3. A numbr of important faturs of th distribution margin data ar immdiatly apparnt. First, margins vary considrably across industris. Scond, thr ar common pattrns across countris in th incidnc of high and low margins for industris. Margins ar consistntly high in furnitur and miscllanous manufacturd goods (36), as wll as in waring apparl and furs (18), tobacco products (16), and fish and fishing products (5). Margins appar to b lowst on som commodity-typ products and industris, such as ptrolum and natural gas (11), ors and mining products (12, 13, 14), and basic mtals (27). Margins on th ordr of 20 prcnt of th producr pric ar commonly obsrvd across industris. Looking in mor dtail within industris, in som cass w ar abl to dcompos th distribution margins into th shar attributd to wholsalrs and rtailrs, vrsus th shar in transport and storag. Th wholsal and rtail componnts dominat distribution costs in almost all industris rporting data, accounting for about 90 prcnt of th total distribution costs addd to th basic prics of goods. Th actual siz of th trad margin is oftn in xcss of 20 prcnt of purchasr prics, and can b as high as 70 to 90 prcnt in som narrow product catgoris. Th transport margins ar typically lss than 5 prcnt of th purchasr prics, with th xcption of som of th mining and xtractiv rsourc industris. Gnrally, ths ar th only industris whr w obsrv transportation margins dominating distribution costs. In Tabl 4, w provid som of this dcomposition information, and also considr th siz of ths distribution margins from th vantag point of countris, rathr than industris. In ordr to construct ths country margins for ach country, w sum ovr th distribution margins for all industris that rport non-ngativ margins (th nt consumrs of distribution srvics), and divid this by th sum of output of all industris nt of th output of thos industris with ngativ distribution margins at purchasr prics. Hr, and in Tabl 5, not that distribution margins ar computd with rspct to purchasr s prics, as in th form prsntd in quation (2) of th papr. As rportd in Tabl 4, w calculat aggrgat distribution margins on th ordr of 15 to 25 prcnt of output for th industris in this industrializd country sampl. Expnditurs 17

20 on wholsal and rtail srvics account for th vast majority of ths distribution margins. Whil thr is cross-country variability, th rang of valus across countris is somwhat narrow, from a low of 8.4 prcnt in Hungary and Finland, to a high of 24 prcnt in th Unitd Stats. Tabl 3 Industry Pattrns of Importd Input Us and Distribution Margin Shars Importd Distribution Margins Product Inputs Total Margins Avrag Max. Min. Avrag Max. Min. 01 Products of agricultur, hunting and rlatd srvics Products of forstry, logging and rlatd srvics Fish and othr fishing products; srvics incidntal to fishing Coal and lignit; pat Crud ptrolum and natural gas, srvics incidntal to oil and gas xtraction, xcluding survying Uranium, thorium and mtal ors Othr mining and quarrying products Food products and bvrags Tobacco products Txtils Waring apparl; furs Lathr and lathr products Wood and wood products Pulp, papr and papr products Printd mattr and rcordd mdia Cok, rfind ptrolum products and nuclar ful Chmicals, chmical products and man-mad fibrs Rubbr and plastic products Othr non mtallic minral products Basic mtals Fabricatd mtal products, xcpt machinry and quipmnt Machinry and quipmnt n..c Offic machinry and computrs Elctrical machinry and apparatus n..c Radio, tlvision and communication quipmnt and apparatus Mdical, prcision and optical instrumnts; watchs and clocks Motor vhicls, trailrs and smi-trailrs Othr transport quipmnt Furnitur; othr manufacturd goods n..c * Product nams givn with CPA Cods (Classification of Products by Activity). Th margins rprsnt th avrag of th wholsal and rtail and transportation margins. Margins ar calculatd as: distribution margins dividd by output at purchasrs or final prics Avrag Country Distribution Margins ar calculatd as th sum of all non-ngativ distribution margins in a country s data, dividd by th sum of all output from all industris (xcpt thos with ngativ margin numbrs). Importd Input shar is calculatd as th avrag of th importd input shar for ach industry. n..c. mans not lswhr classifid. Th sampl includd ar th countris and yars rportd in th first two columns of tabl 4. 18

21 Tabl 4 Shar of importd inputs in total costs and shar of distribution margins in purchasrs prics, by country* Country Rfrnc Yar Shar Importd Inputs Shar Distribution margins Avrag Max Min Australia 2000/ Austria** Blgium Dnmark Estonia Finland Franc Grmany Grc Hungary Irland Italy Nthrlands Nw Zaland 1995/ Norway Poland Portugal Spain Swdn Unitd Kingdom** Unitd Stats * Importd input ratios rfr to th ratio of importd inputs to total inputs in all industris in ach country, with th xcption of th US, that rfrs to manufacturing only. Margin calculations for ach country ar takn as th simpl avrag of all distribution margins rlativ th purchasrs prics for th 29 homognous industris rportd in Tabl 3. Total margins may not qual th sum trad and transportation margins du to rounding. ** Th data for importd inputs for Austria rfrs to 2000 and for th Unitd Kingdom to C.- Distribution margins by componnt of final dmand Th rportd margins in th prvious sction rfr to th distribution margins for aggrgat final dmand in ach industry or country. Howvr, margins diffr substantially across th componnts of final dmand. For CPI discussions, w look xclusivly at margins that apply to consumption dmand. To illustrat th stark diffrncs in margins across catgoris of final dmand, Tabl 5 prsnts comparisons of margins across houshold consumption, fixd 19

22 capital formation, and xports. For ach of ths final dmand catgoris, w rport th total distribution margins and thir brakdowns btwn transport vrsus wholsal and rtail componnts. Tabl 5 clarly shows that total distribution margins on houshold consumption goods ar much largr than thos applid to invstmnt or xport goods. Total distribution margins in houshold consumption rang from a low of 32 prcnt of purchasr prics in Estonia to a high of 50 prcnt in th Nthrlands. Distribution margins ar abov 33 prcnt for almost all countris in th sampl (xcpting Estonia and Portugal). By contrast, distribution margins in fixd capital formation ar substantially lowr. Th largst distribution margin in fixd capital formation, for Austria, is prcnt, followd by Dnmark and Blgium. Distribution margins in fixd capital formation ar blow 10 prcnt of purchasr costs for 7 out of 19 countris in th sampl. Margins in xports ar also smallr than margins in houshold consumption. Th avrag distribution margin in xport industris is 13 prcnt, with a wid rang in thir valus. Nordic Europan countris tnd to hav vry low distribution margins on xports, with rlativly larg margins on houshold consumption. Th contribution of wholsal-rtail and transportation to th total distribution margins also varis by final dmand componnt. Whil transportation accounts for a significant portion of total distribution margin in xports, its contributions to th total margins for consumption and gross-fixd capital formation ar significantly lowr. Th transport margin in xports is largr than th wholsal rtail margin for 11 countris in th sampl. In houshold consumption, th country with th largst transportation margin rlativ to th wholsal-rtail portion is Norway, with transportation margins bing 40 prcnt of th siz of th wholsal-rtail margins. For th typical country, transport margins mak up lss than 20 prcnt of th total margin in consumption. Finally, transportation margins ar particularly low for gross-fixd capital formation. Th mdian transportation margin in invstmnt is 0.6 prcnt. Wholsal and rtail margins ar also significantly lowr for invstmnt rlativ to othr final dmand componnts, but vn aftr taking this into considration, th rlativ contribution of transportation to total margins is lowr for invstmnt. 20

23 Tabl 5 Distribution Margins by Sourc of Final Dmand (Prcnt) Country Yar Wholsal- Houshold Consumption Fixd Capital Consumption Export Rtail Transport Total Wholsal -Rtail Transport Total Wholsal -Rtail Transport Australia 2000/ Austria Blgium Dnmark Estonia Finland Franc Grmany Grc Hungary Irland Italy Nthrlands Nw Zaland 1995/ Norway Poland Portugal Spain Swdn Unitd Kingdom Unitd Stats Total D. Importd Inputs into Production W masur th siz of importd inputs for all industris in th input-output tabls. For comparison with th distribution margins, w rport in th first columns of Tabls 3 and 4 th importd input masurs calculatd for th sam st of industris for which w hav calculatd distribution margins, i.. for 29 homognous manufacturing and primary-industry groupings. A clar pattrn mrgs from Tabl 3. Industris involvd in agricultur and commodity production hav much lowr shars of importd inputs than industris in th manufacturing sctor. For instanc, Forstry, Logging and Rlatd Srvics and Coal and Lignit hav importd input shars of around 13 prcnt of total costs. By contrast, all manufacturing industris hav importd input shars abov 20 prcnt. Within th manufacturing sctor, 21

24 Chmicals has th largst shar of importd inputs, 67 prcnt of total costs, followd by lctrical machinry and mdical and prcision instrumnts, both with importd input shars abov 50 prcnt. Th industris within manufacturing with th lowst importd input shars ar forstry and mtal ors. Th disprsion of importd inputs into production also diffrs significantly by country. Tabl 4 rports th avrag importd inputs into production for all industris. This masur includs not only th industris rportd in Tabl 3 but also othr industris such as Elctricity, Transportation, Trading, Insuranc, Financ and Othr Srvics. In gnral, largr countris hav a lowr shar of importd inputs into production whil smallr countris hav a highr shar. Th Unitd Stats has th lowst ratio of importd inputs into production of all countris in th sampl, although its data is not fully comparabl sinc it rfrs to only manufacturing industris. Th nxt lowst is Franc. Irland, with 49 prcnt, has by far th largst ratio of importd inputs into production. Othr smallr countris lik Blgium, Hungary and Portugal also hav larg ratios of importd inputs into production. Th rol of importd inputs diffrs substantially btwn manufacturing industris and othr industris. W alrady discussd that manufacturing industris hav a much largr shar of importd inputs than Agricultur and Mining. In th appndix w prsnt th ratio of importd inputs in th production of othr non-manufacturing industris, mainly Enrgy, Construction, Transportation, and Srvics. Importd inputs hav a larg shar of costs of production mainly in thos industris with a larg consumption of nrgy products as raw matrials. Ths industris includ Elctricity, Gas, Stam, Watr and Air Transport. Importd inputs ar also important for Rpair of Motor Vhicls as auto parts ar a highly tradabl industry. For th othr nonmanufacturing industris, importd inputs play a minor rol, with ratios almost always blow 20 prcnt of production costs. E. Do Distribution Margins Rspond to Exchang Rat Fluctuations? As discussd in sction 2, xchang rats may influnc profit margins, both at th lvl of initial producrs and again at th lvl of wholsalrs and rtailrs. Th spcific siz of this rlationship dpnds on th comptitiv structurs assumd and th rlationship btwn th 22