Abstract
This paper theoretically explores how exchange rate pass-through depends on firm heterogeneity in productivity and product differentiation in quality. Using an extended version of the Melitz and Ottaviano (2008) model, I show that exporting firms absorb exchange rate changes by adjusting both their markups and product quality, which leads to an incomplete exchange rate pass-through. Moreover, the absolute value of exchange rate absorption elasticity (the percentage change in the export prices denominated in the currency of the exporting country in response to a one percent change in the exchange rate rate) negatively depends on firm productivity for products with high scope for quality differentiation, but positively depends on firm productivity for products with low scope for quality differentiation.
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