Working Paper no. 178
By Colin Ellis and Simon Price
Modern open-economy macro models emphasise pricing-to-market behaviour. It is possible that domestic pricing behaviour might be affected by import (competitors’) prices, and this is a commonly used variable in empirical work on pricing. But there is theoretical ambiguity and a potential identification problem. Cointegrating techniques are used in an attempt to resolve this, using the most appropriate data set (producer prices). Some evidence is found for the existence of two long-run relationships. The first of these is interpretable as a price mark-up or factor demand relationship, and competitors’ prices can be excluded from it. The second equation can be interpreted as a long-run equilibrium price relationship equating domestic and foreign prices. This raises the possibility that single-equation estimates indicating a role for foreign prices in domestic price determination may mislead. However, the results are for producer prices and may not necessarily be extended to other indices.