Equation (1) gives the estimating equation used to determine the exchange rate passthrough
and elasticity of substitution.
V
^
ijt–V
^
jjt= β0 + β1P
^
jjt + β2Σk
θkit (P
^
kkt–E
^
kjt) + ηijt. (1)
The variable V
^
jjt is the first difference of the log of the value of domestic shipments
in country j in year t, V
^
ijt is the first difference of the log of the value of exports from
country i to country j in the currency of country j , P
^
jjt is the first difference of the log of
the price of domestic goods in country j in the currency of country j , and E
^
kjt is the first
difference of the log of the country k currency price of the currency of country j. The
variable θkit represents the cost share of country k in the sector’s exports from country
i in year t. Finally, the variable ηijt is an error term with conventional distributional
assumptions. We do not include a subscript for sector, since we estimate a separate
set of econometric models for each sector. We can recover the underlying parameters
of the model from the regression coefficients in (1). The elasticity of substitution, σ, is
equal to 1+β1. The exchange rate pass through rate, λ, is equal to –β2/β1.