Imports and RMB exchange rate pass-through: The role of quality sorting

Abstract

This paper examines how the use of imported intermediate inputs affects the exchange rate elasticity of export prices. We first construct a theoretical model to illustrate that a change in imported input cost followed by a change in the exchange rate affects export prices through two distinct channels: directly changing the marginal cost of export products(i.e., the marginal cost channel) and indirectly altering exporters’ incentive to upgrade (or downgrade) the quality of products (i.e., the quality change channel). These two channels generate opposite effects on the exchange rate elasticity of export prices. Our empirical analyses find strong evidence of the existence of the marginal cost and quality change channels. Overall, the marginal cost effect dominates the quality change effect. The marginal cost channel is weaker for products with larger scope for quality differentiation and firms with a higher ability to upgrade quality, as predicted by the theoretical model.