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[2014-11] Effect of Exchange Rate Fluctuations on Domestic Service Prices

Personnel Department 2014.12.12 6316

With the degree of Korea’s economic openness steadily growing, there is a strong possibility that the impact of overseas factors on service prices has become more pronounced than in the past. For instance, changes in external factors such as the exchange rates cause changes in households’ purchasing power, which affects demand for services, consequently leading to adjustment of charges for services. It is quite well possible that this transmission channel may have increased as the elasticity of the substitution of imported goods for domestic goods has increased encouraged by the widening of external openness. Most previous studies on exchange rates and inflation, however, have only analyzed how exchange rate fluctuations affected overall consumer prices through import prices. This paper consequently looks at the effects of exchange rate fluctuations on service prices through the channels of households’ purchasing power and corporations’ price determinations.
According to the results of the empirical analysis of the effects of exchange rates on Korea’s service prices, they were not evident before the global financial crisis (from January 2000 to December 2007), while showing a significant negative relationship after the crisis (from January 2011 to December 2013). Moreover, when the effects are estimated for periods of exchange rate rises and declines, they appear asymmetrical: they were insignificant during upticks since the crisis while showing a significant negative relation during downturns. These results seem attributable to the increased income effect of exchange rate fluctuations on service prices through changes in households’ purchasing power since the financial crisis. In addition, asymmetry appears
to arise from corporations’ tendency to raise their mark-up ratios during periods of exchange rate falls but keep them unchanged when exchange rates are rising, due to the poor viability of the service industry.

These results show that a fall in exchange rates generally leads consumer prices to decline owing chiefly to the lowering of import prices while pushing service prices up through channels such as those of purchasing power and mark-up ratios.