The Effect of Import Price Changes on Domestic Inflation: An Empirical Test of the Ratchet Effect: Note

Abstract

The possibility of downward rigidity of wages and prices has been considered in the literature at least since Keynes' General Theory. Many argue that monopolistic forces such as oligopolies and unions respond to inflationary pressures by raising wages and prices but resist wage and price reductions. l To the extent that these entities resist downward wage and price movements, they contribute to the existence of a ratchet effect, in which wages and prices behave asymmetrically. The issue of a possible ratchet effect is particularly important in the context of international price movements. Commonly known as the Mundell-Laffer hypothesis,2 the ratchet effect implies an upward bias in the response of domestic prices to changes in import prices. Consider the effect of an exchange rate movement on prices. Depreciation raises import prices, thereby increasing the domestic price level. The question is whether appreciation causes an equal downward movement in prices. For example, a 10 percent exchange rate depreciation followed by 10 percent appreciation would leave the exchange rate intact, but may leave domestic prices higher than the original level. If prices adjust asymmetrically throughout the world, such an exchange rate movement would result in higher world prices. Despite the attention this issue has received in the theoretical literature, little empirical work has been devoted to it. In a discussion of the literature Ahmad ( 1984, p. 4) assumes the ratchet effect is significant and inflationary. In empirical research, Sachs (1985) and Feldman (1984), among others, make the opposite assumption. In the only paper devoted to empirical testing of the ratchet effect, Goldstein (1977) presents evidence that price movements are symmetric, but his