| Impact of exchange rate movement on the economy, in particular prices and quantities of traded goods, has become the subject of major research and investigation, ever since the breakdown of the Bretton Woods system in 1971. Research in this area covers both the theoretical aspect of the exchange rate fluctuation and the empirical evidence. Prices of traded goods have been found to move only partially in response to exchange rate changes, a phenomenon termed as ‘incomplete pass-through’. In an imperfect market set-up, foreign firms increase the prices of their products whenever the cost rises, due to a devaluation of the domestic currency. However, in a dynamic framework, they may even reduce the prices, depending on the expectation about the nature of the exchange rate change, that is, whether it is temporary or permanent. However, in all these different types of modeling, the product quality has been assumed to remain unchanged in the face of a cost shock.; This essay takes into consideration a very vital component of exchange rate analysis that has been overlooked so far. In other words, I assume that quality characteristics change when costs change, instead of remaining constant. This assumption proves to be crucial, because even in a static framework, the prices of traded goods are found to falling quite often, instead of rising. Thus the foreign firms are responding to the cost rise by reducing their prices, through changes in the quality of their products. The pattern of change in the quality and price is found to be quite sensitive to the nature of the foreign firm, and the nature of product differentiation. On the other hand, under the assumption that the foreign firms would never change quality-characteristics of their products, it was observed that the prices rise, irrespective of the nature of foreign firm, and the nature of product differentiation. Empirical estimation supported the theoretical predictions in most cases. |
