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Exchange rates and perfect competition


Hens, Thorsten (1997). Exchange rates and perfect competition. Journal of Economics, 65(2):151-161.

Abstract

The purpose of this note is to demonstrate that the commonly held belief that incomplete and perverse pass-through are incompatible with perfect competition is wrong! To this end, we consider two types of firms both operating in two countries. The demand sides of the markets of the two countries are separated and each type of firm produces its good in one of these countries. We study the effect of an exchange-rate change on the competitive equilibrium prices in each country. When producing for the foreign market causes the same costs as producing for the home market then the “law of one price” holds and an exchange-rate change is completely offset by price changes. Furthermore, when cost functions neither exhibit economies nor diseconomies of scope between producing for the home and producing for the foreign market then prices move in the “right” directions in response to an exchange-rate change. However, with general cost structures, even in this simple perfectly competitive model, “perverse” directions of price changes can result from an exchange-rate change.

Abstract

The purpose of this note is to demonstrate that the commonly held belief that incomplete and perverse pass-through are incompatible with perfect competition is wrong! To this end, we consider two types of firms both operating in two countries. The demand sides of the markets of the two countries are separated and each type of firm produces its good in one of these countries. We study the effect of an exchange-rate change on the competitive equilibrium prices in each country. When producing for the foreign market causes the same costs as producing for the home market then the “law of one price” holds and an exchange-rate change is completely offset by price changes. Furthermore, when cost functions neither exhibit economies nor diseconomies of scope between producing for the home and producing for the foreign market then prices move in the “right” directions in response to an exchange-rate change. However, with general cost structures, even in this simple perfectly competitive model, “perverse” directions of price changes can result from an exchange-rate change.

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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Scopus Subject Areas:Social Sciences & Humanities > General Business, Management and Accounting
Social Sciences & Humanities > Economics and Econometrics
Scope:Discipline-based scholarship (basic research)
Language:English
Date:June 1997
Deposited On:24 Nov 2020 09:27
Last Modified:24 May 2024 01:42
Publisher:Springer
ISSN:0931-8658
OA Status:Closed
Publisher DOI:https://doi.org/10.1007/BF01226932
Related URLs:https://link.springer.com/article/10.1007%2FBF01226932 (Publisher)
Other Identification Number:merlin-id:19959
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