"Lost in Transit: Product Replacement Bias and Pricing to Market"
Publication type: Working paper
Research Archive Topic: Corporate Finance
Product replacement is frequent in the micro-data that underlie U.S. import and export price indices, while price changes are infrequent. Consequently, over 40% of price series in the data have no price changes and roughly 70% have two price changes or less. In constructing price indices, price adjustments that occur at the time of product replacements tend to be dropped. If price adjustments disproportionately occur at the time of product replacements then price adjustments are disproportionately unobserved. We show that this "product replacement bias" may distort the measured long-run relationship between import and export prices and the exchange rate by a factor of between 1.7 and 2.2. Accounting for this bias, we find that the price of non-oil U.S. imports (relative to domestic consumption) responds by 0.6-0.7% for each 1% change in the U.S. real exchange rate, while the price of U.S. exports (relative to foreign consumption) responds by roughly 0.8%. This contrasts with conventional pass-through estimates of 0.2-0.4% for non-oil import prices and 0.9% for export prices. Thus, we find that the degree of pricing to market for U.S. imports and exports is more symmetric and the degree of pricing to market for U.S. imports more moderate than conventional measures suggest. Adjusting for product replacement bias also substantially raises the volatility of the terms of trade. These results improve the fit of the data to standard models.
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