Pass-through of external shocks along the pricing chain: A panel estimation approach for the euro area

incentive to raise its price. Thus, in general, a natural link between movements of raw
material prices and exchange rates, producer prices and consumer prices exists. Hence, the
basic set-up should reflect the pricing chain according to the causalities as shown in Table 1.

Table 1 Possible causalities between price variables

NEER: nominal effective exchange rate of the euro; COMENE: energy commodity prices in USD; COMFD: food
commodity prices in USD; COMIRM: industrial raw material prices in USD; VAT: value added tax; ULC: unit
labour costs; YGAP: output gap; EXTRA_OPEN: extra-euro area trade openness; ENETAX: energy taxes;
PPI_ENE: PPI energy; PPI_INT: PPI intermediate goods; PPI_CONS: PPI consumer goods; HICP_FDPR:
HICP processed food; HICP_NEIG: HICP non-energy industrial goods; HICP_SERV: HICP services.

For all endogenous variables (PPI and HICPX components, columns in Table 1), production
costs are represented by exchange rates, commodity prices and unit labour costs (exogenous
variables, rows 1-9 in Table 1).³ To reflect the idea of a pricing chain, sectoral prices at earlier
stages of the production chain are also recursively included in the production costs of sectoral
prices at later stages. This means that PPI energy is explained only by the exogenous
variables (and its own lags), while, in addition to the exogenous variables,

- PPI intermediate goods is explained by PPI energy;

- PPI consumer goods is explained by PPI energy and PPI intermediate goods;

- HICPX components, i.e. processed food, non-energy industrial goods, services, are
explained by PPI energy, PPI intermediate goods and PPI consumer goods. However,
linkages between the components of the HICPX are not considered. The model does
not make a difference between the determination of consumer goods and services
prices from the outset but let rather the data decide.

³ Moreover, we have included the output gap (as a proxy for changes in domestic demand conditions)
to allow for a flexible mark-up. Given the importance of indirect taxes on price developments, we also
include VAT and energy taxes in the mark-up equation.

■ ECB

Working Paper Series No 1104

November 2009

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