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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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7.3 Empirical Evidence on the LOP

7.3.1 Early Tests of the LOP

In general, the early econometric studies suggest rejection of the LOP for a broad range of goods and provide empirical evidence both that deviations from the LOP are highly volatile and that the volatility of relative prices is considerably lower than the volatility of nominal exchange rates. This is suggested, for example, by two influential studies carried out in the 1970s. Isard (1977) uses disaggregated data for a number of traded goods and for a number of countries, providing empirical evidence that the deviations from the LOP are large and persistent, and they appear to be highly correlated with exchange rate movements. Richardson (1978) finds very similar results to Isard, by using data for four- and seven-digit standard industrial classification (SIC) categories.4

Implicit in the LOP is the assumption that exporters maintain their local currency price in the face of exchange rate movements such that exchange rate pass-through to importers is complete. In this case, we observe the so-called producer-currency pricing. Alternatively, if exporters lower their export prices to fully offset exchange rate changes, prices in the importer's currency will be unchanged, and we observe local-currency pricing and an exchange rate pass-through of zero.

In an early study, Kreinin (1977) documents exchange rate pass-through rates of between 50% (to US import prices) and 100% (for Italian imports). Knetter (1989, 1993) uses ...

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