1. Introduction
Since the start of Stage III of the European Monetary Union (EMU) in January 1999, the euro
area has been subject to a large number of external shocks such as a significant increase in oil
prices, substantial fluctuations in its effective exchange rate and, more recently, a strong
increase in non-energy commodity prices. Such movements can generally be expected to
impact, inter alia, significantly on price developments. So far, the literature has covered the
impact of exchange rates on headline and core inflation in the euro area or a number of euro
area countries (see for example, Gagnon and Ihrig (2004), Choudhri et al. (2002), Choudhri
and Hakura, (2002), Faruqee (2006), Hahn (2003), Hüfner and Schroder (2002), Campa and
Gonzalez Minguez (2006), Campa and Goldberg (2006a and b), McCarthy (2000) and Bailliu
and Fujii (2004). The question how euro area prices, foremost consumer prices, react to a
change in energy prices has been analysed primarily in the context of macro-econometric
models such as the ECB AWM, the Quest Model of the European Commission, OECDs
interlink and the NiGEM, using however oil rather than overall energy prices. Quite a number
of recent studies have looked at the possibility of a change in the impact of exchange rates
(see for example Bussière and Peltonen (2008), Campa and Goldberg (2006b) and Gagnon
and Ihrig (2004)). Overall, only few studies have analysed a pricing chain, i.e. the
transmission of such shocks via production costs to consumer prices (see for example Hahn
(2003), Faruqee (2006) and McCarthy (2000)2, who conduct the analysis within a VAR
approach). None of the studies has, to our knowledge, considered the transmission via
different sectors in such a pricing chain framework, particularly regarding the difference in
the transmission between tradable (goods) and non-tradable (services) prices. Hahn (2007)
has analysed the impact of exchange rates on sectoral producer prices without, however,
estimating a pricing chain framework.
The purpose of this paper is to analyse in a mark-up framework the pass-through of external
shocks (commodity prices, split into energy and non-energy commodities, and exchange
rates) to the main components of the producer price index (PPI) and the Harmonised Index of
Consumer Prices excluding energy and unprocessed food (HICPX). The general idea is to
link movements in prices at the different stages in production as, in theory, a firm sets its
prices as a mark-up over (marginal) production costs. Consequently, for a given profit
margin, an increase in the price of a material input will push costs up, giving a firm an
2 Note that McCarthy (2000) finds only a modest effect of exchange rates, while import prices have a
stronger effect. For most countries in his analysis, he finds non-significant results.
ECB
Working Paper Series No 1104
November 2009∣ 7