TITLE : [Economic Papers 5-2]
          Invoice Currency and Exchange Rate Pass-Through of Korean Exports: Theoretical Explanations
AUTHOR : Seong-Hun Yun
CONTACT : Institute for Monetary & Economic Research
             (tel: 82-2-759-5407, 5421 fax: 82-2-759-5410)
ATTACH : EP5-2-06.pdf

Summary:
      
    Existing literature regarding the exchange rate pass-through of Korean exports chose either the won/U.S. dollar (henceforth dollar) exchange rate or the trade weighted exchange rate as an exchange rate variable, when they estimated it. The estimated exchange rate pass-through was much higher in the former case than that in the latter, which made it hard to interpret the pricing behavior of Korean exporting firms whether it is producer currency pricing or local currency pricing. This paper examines the validity of the won/dollar exchange rate and the trade weighted exchange rate as the exchange rate variable, considering  most Korean exports are invoiced in dollars.
  When exports are denominated in dollars, the implications of the won/dollar exchange rate and the trade weighted exchange rate as the exchange rate variable are different. Use of the won/dollar exchange rate means that the destination currency/dollar exchange rate is implicitly assumed to have no effect on export prices, while use of the trade weighted exchange rate means the won/dollar exchange rate is implicity assumed to have the same effects on export prices in absolute values as the destination currency/dollar exchange rate. However, these assumptions would be inappropriate if the dollar invoiced imported inputs, non price discrimination in dollars across destination markets, menu costs of invoice price changes, and different exchange rate expectations play some roles in the process of export price determination. I provide four theoretical explanations of why they may well be inappropriate.
  If this is indeed the case, as most exports are invoiced in dollars like Korean exports, we should test the validity of both the won/dollar exchange rate and the trade weighted exchange rate as the exchange rate variable by undertaking a model selection procedure before estimating the exchange rate pass-through.