Working Paper Series no. 797: Global Value Chains and the transmission of exchange rate shocks to consumer prices

Following the 2008 financial crisis, inflation rates in advanced economies have been a puzzle. The apparent disconnection between inflation and its traditional domestic drivers triggered a debate on the potential growing role of global determinants. We contribute to this debate by investigating the impact of global value chains on inflation dynamics over the past twenty years on a sample of 43 economies.

Participation in global value chains strengthens cross-country linkages via trade in intermediate inputs. When value chains are global, fluctuations in exchange rates affect household consumption expenditure deflator (HCE hereafter).

Assuming a Cobb-Douglas production framework where firms follow a simple cost-minimising behaviour, we compute the partial-equilibrium effects of an exchange rate shock on consumer prices. We use world input-output tables covering twenty years of data (from 1995 to 2015). We analyse the impact of exchange rate shocks on the main components of consumer prices and on the prices of imported and domestic final goods. We confirm the importance of global value chains in explaining inflation dynamics. We find that the elasticity of the HCE to exchange rate shocks ranges from 0.05 to 0.35, depending on the openness rate of each economy. In the euro area, the elasticity of the HCE deflator to changes in the euro exchange rate ranges from 0.07 to 0.18.

We show that the direct impact (through imported final goods) and domestic input-output linkages (i.e. domestic final goods produced using foreign inputs) account for most of the propagation of an exchange rate shock to domestic prices. First-round effects explain three-quarters of the propagation of exchange rate shocks to domestic prices. By contrast, we find a limited role for the second-round effects, i.e. the additional transmission of lower domestic input prices. Domestic core inflation (defined as inflation excluding food and energy) accounts for a significant share of the total elasticity, mainly reflecting the weight of domestic services and non-energy industrial goods in total consumption.

The construction of World Input-Output tables (WIOT hereafter) is data-demanding and WIOTs are typically released with a lag of several years (2015 at the time of writing). To address this gap, we show it is possible to exploit more up-to-date GDP and trade data to approximate the impact of an exchange rate shock on the HCE deflator for recent years. We analyse time variation in the elasticities over the past two decades. On our sample of 43 countries, the mean output-weighted elasticity of the HCE deflator to exchange rate shocks increased from 0.08 in 2000 to 0.09 in 2008. The elasticity declined in subsequent years. Extrapolations suggest that this decline was reversed in 2017 and 2018 (see figure).