The Interaction of Foreign Exchange and Market Power Effects on German Domestic Prices

Abstract

This paper illustrates the importance of international influences on domestic markets. A model is presented in which changes in a country's terms of trade pass to industrial prices in varying degrees depending on import penetration and seller concentration. Empirical results suggest that the 8.4 percent decline in the real external value of the Deutsche Mark from 1977 to 1983 allowed upward movement of about 2 percent in domestic producer prices of relative to the GNP price deflator. Increased market concentration led to a reduced effect, while increased import penetration led to some increase in the exchange rate passthrough. STANDARD INDUSTRIAL organization models stress the impact of market power and entry conditions on economic performance, with particular interest in price effects. At the industry level, greater concentration is expected to lead to higher prices, ceteris paribus, while greater ease in entry (or a larger competitive fringe) implies lower prices. The international economics literature indicates that, in the absence of trade barriers, transactions and transportation costs, and market power, foreign exchange rate changes will be fully passed through to import and export prices, implying that domestic prices of traded goods for an appreciating currency will be adjusted downward by the full amount of the exchange rate change. The dramatic changes in exchange rates since the early 1970s provided exporters with new opportunities to enter markets of nations that had a strong currency. West Germany has been regarded as one such country. This paper investigates the effect of exchange rate movements on particular German industrial prices. I test to see whether the prominence of imports