Hysteresis in Import Prices: the Beachhead Effect

Abstract

International economists typically assume that temporary real exchange rate shocks can have only temporary real effects -and no effect at all on the underlying structure of the economy. This paper shows that even in a simple "off-the-shelf" industrial organization model, this assumption is unfounded; if market-entry costs are sunk, exchange rate shocks can alter domestic market structure and thereby have lasting real effects. In other words, a sufficiently large exchange rate shock can cause hysteresis in import prices and quantities. This simple idea has strong implications for exchange rate theory (Baldwin and Krugman 1986 shows this), for trade policy (Dixit 1987a discusses this), and for the estimation of trade equations as the present paper shows. To show that the theoretical point is not just empirically empty theorizing, we present evidence which suggests that the recent dollar overvaluation is an example of a hysteresis-inducing shock. To this end we demonstrate that the pass-through relationship shifted in a manner that 13 consistent with the nature and timing of the market structure changes predicted by the model. In particular, we find evidence that the structural break occurred during the rising dollar phase rather than In 1985 as is commonly asserted. A direct test of the model is not performed due to data limitations.