LINEAR REGRESSION ANALYSIS

Linear Regression Analysis

Linear Regression Analysis

The impact that movements in nominal exchange rates have on the geographical allocation of economic activity and the volume of trade has been at the core of research in international economics for over three decades. One key point in this debate is the degree, speed and form in which domestic prices of imported products adjust to exchange rate changes. It is often reported that the high volatility of nominal exchange rates is not matched by the behavior of import prices, which tend to be far less volatile. This gives rise to fluctuations in real exchange rates (the exchange rate adjusted for relative prices) which have been seen to be large and persistent over the past three decades, suggesting that the adjustment of import prices is very slow. Several reasons have been suggested for such a slow adjustment of import prices. These include the existence of product differentiation and imperfect competition that can isolate, at least partially, foreign producers' pricing policies from exchange rate changes (implying price differentials between domestically produced and imported tradable products), and the presence of price rigidities driven by some form of fixed cost to changing prices. Understanding the speed and the form in which the adjustment of import prices - and, thus, real exchange rates - to their long-run equilibrium takes place is an important issue in order to comprehend and anticipate inflation developments and, consequently, to provide an appropriate policy response by monetary policy authorities (Burstein et al., 2003).

The adjustment of import prices to nominal exchange rate changes has also been an important part of the economic policy debate within the European Union (EU). The adoption of the euro by a subset of twelve countries and the large fluctuations in the value of this currency relative to the US dollar have led to a profound interest in the underlying determinants of import prices and their relationship with exchange rate and monetary conditions. As far as non-linear adjustments are concerned, we considered three different possibilities: that they increase with the size of the deviation (non-proportionality); that they are asymmetric with respect to the sign of the deviation and, finally, that certain thresholds in the size of the deviation exist below which no adjustment takes place. We test these ideas by modeling the process driving foreign prices, nominal exchange rates and import prices in domestic currency allowing for non-linear adjustments. We use ...