Credit: Shutterstock photoWherever you live, the price of goods and services are usually stable. Whether that’s the cup of coffee you pick up every morning or the paycheck you receive every two weeks, the value rarely changes. However, in reality, exchange rates change every second, and have inherent implications on business activities within and between economies.
Exchange rate shocks have a significant impact on inflation, interest rates, and trade, just to name a few. Rate shocks is a term used to describe when the value of one currency spikes relative to another in an extremely short period of time. Beyond directly influencing different economic channels, FX shocks have policy implications which are not as easily understandable. If an incident causes a change in import prices or domestic inflation, then subsequent monetary policies should be enacted to counter them. That said, economic theory doesn't always match up to what happens in the real world.
Economic Theory
Flashback to macro 101 and you know that exchange rates affect a number of factors in the global economy. Most importantly, they affect inflation through direct and indirect channels. If the U.S. dollar appreciates, this directly causes the price of imports to decline. Conversely, higher exchange rates make it harder to export goods overseas. Since commodities are also quoted in dollars, any domestic rate shock impacts the commodities market. Like exports, a stronger dollar makes it more expensive for global countries to access commodities.
Rate shocks also indirectly influence unemployment rates. In economics, the relationship between inflation and unemployment is characterized by the Philips curve. The Philips curve basically says that a decline in inflation will lead to greater unemployment. However, if inflation rises because of increased competitiveness, it shouldn't cause higher unemployment as the Philips curve suggests.
Economic Reality
Unfortunately, economic theory doesn’t always reflect what actually happens in real life. Theoretical economics often fail to recognize behaviors and adjustment periods. According to theory, when one event takes place, the next event in the chain must occur immediately thereafter. However, in reality, prices don’t adjust instantaneously and are sometimes completely unaffected. When measuring the impact of an exchange rate shock, we must take into account how rigid or elastic prices are. In this scenario, nominal rigidity, or price-stickiness, describe a situation in which prices are resistant to shocks.
Domestic Prices
Exchange rate shocks affect domestic prices in two ways. The first is a direct effect on marginal costs, and as exchange rates rise, imports become cheaper. In essence, this is traditional economic theory. However, this more nuanced approached interprets these effects across different industries and products.
For example, a strong U.S. dollar makes importing intermediate inputs cheaper. Intermediate inputs of an industry are goods and services such as energy, raw materials, semi finished goods that are used in the production process of final consumable products. As a result, the marginal cost of domestic products is lower as well. This effect is more noticeable for large corporations that source inputs from abroad.
The second and more unconventional aspect of rate shocks indirectly affects the markup prices of final goods. Domestic manufacturers are inclined to lower their prices if the cost of an import is significantly cheaper. In addition, domestic prices may change purely in response to competitor’s prices, regardless of marginal costs. Research from the New York Fed found that companies adjust their prices by 0.3% following a 1% change in price from a close competitor.
Smaller firms typically do not respond to these fluctuations, and large corporations usually only act under certain circumstances. Furthermore, larger firms are more likely than a small business to pass rate shocks through domestic prices. In other words, Walmart will raise prices after a shock while prices at the mom and pop store will remain unchanged.
Since corporations generally purchase goods from abroad, they are more adversely impacted from volatile FX trends. Simply, domestic prices respond to shocks in industries with high import volume, a large global presence and operate in a concentrated market.
International Prices
As you might suspect, international prices react differently to exchange rate shocks. Research from the National Bureau of Economic Research (NBER) found that international prices of traded goods exhibited one year of nominal rigidity, or price stickiness, regardless of how volatile rates were. This means that shocks only yielded small price movements over a short to medium term.
Final Take
Exchange rates are one of the few variables which have deep rooted effects on both domestic and international prices. These relationships are far more nuanced than traditional theory has defined. Modern research has found they vary across industries, competitive landscapes, and level of international exposure, to name a few. While rate shocks can be difficult to understand, they play an important role in creating an effective pricing strategy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
