Economic Analysis (EA) Research Paper Series

11F0027MIE

Domestic and Foreign Influences on Canadian Prices over Exchange Rate Cycles, 1974 to 1996

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Domestic and Foreign Influences on Canadian Prices over Exchange Rate Cycles, 1974 to 1996

by John R. Baldwin and Beiling Yan

Executive summary

What factors affect Canadian price formation in the manufacturing sector? Economic theory offers a host of possible explanations. Some models assume closed economies and make use of a cost mark-up pricing rule. Here, industries are hypothesized to base their selling prices on unit costs and targeted rates of return (the mark-up). Others assume a perfectly competitive and integrated world, where prices are governed by the law of one price (LOP). Here, prices of a homogeneous product are set equal to world (United States in this case) prices after adjusting for transport costs, the tariff rate and the exchange rate.

This paper examines the pricing behaviour of 81 Canadian industries over the 1974-to-1996 period. It asks which rule explains the price formation process in Canada and under which circumstances Canadian prices are more affected by foreign (U.S.) prices as opposed to domestic factors such as labour and materials costs and productivity. In particular, it asks:

1. How are prices formed in Canada? Which rule explains price movements?
   Canadian manufacturing prices are, on average, neither exclusively governed by the mark-up pricing rule nor by the LOP rule. They are set in accordance with a mixture of both rules.

2. When are Canadian prices more subject to foreign influences?

   Prices for domestic products are more sensitive to U.S. prices if the Canadian industry faces higher import competition, and if home and foreign products are less differentiated.

   Compared to prices of domestic products, prices of imported foreign products are more responsive to foreign prices. However, in pricing their imports, importers do not merely pass through all foreign price changes to Canadian import prices; they also adjust to the local market conditions (i.e., the Canadian costs of labour, materials and energy). Import prices reflect domestic prices more (the pricing-to-market phenomenon) when import market share is lower.
   Industry differences in price responses exist and are large.

By tying the short-run behaviour of prices to their long-run values, the paper also estimates the speed of price adjustment and evaluates how it varies with exchange-rate movements. It asks:

1. What are the factors that drive short-run price fluctuations? What is the speed of price adjustment?

   The short-run fluctuations in the prices of domestic and imported foreign products reflect current changes in foreign prices and domestic economic conditions. They also move to correct disequilibria that were generated by previous shocks.

   It takes around 3.6 years for 50% of the discrepancy between the actual and the long-run equilibrium value of domestic output prices to be eliminated. It takes 6.6 years for import prices to do the same.

2. Under what circumstances do Canadian prices react more to disturbances in foreign prices? And how does the speed of adjustment vary across the exchange-rate cycle (periods of appreciation as opposed to depreciation)?

   As Canada's international competitiveness deteriorates in a period of an appreciating Canadian dollar, changes in Canadian prices are more responsive to fluctuations in foreign prices. When the Canadian dollar appreciates, products from Canada become relatively more expensive. In competing with foreign products, home producers have to price their products closer to their foreign counterparts when the dollar appreciates.

   As Canada's international competitiveness improves in a period of a depreciating Canadian dollar, changes in Canadian prices are more responsive to cost changes at home and less to foreign prices. When the Canadian dollar depreciates, Canadian industries enjoy a relative cost advantage. This provides more room for domestic product prices to adjust to the cost conditions at home and to their long-run equilibrium.

   The speed of adjustment toward equilibrium is faster when the pressure from foreign markets increases in a period of an appreciating Canadian dollar than in a period of a depreciating Canadian dollar.

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