The Effect of Exchange Rate Fluctuations on Product Quality

The adjustment of export prices to exchange rate fluctuations has received considerable attention and consensus has been reached about the extent of this so called exchange rate pass-through. However, there has been no research yet on the adjustment of product quality of exports to exchange rate fluctuations. In this thesis a theoretical model by Moraga-González and Viaene (2004) is numerically simulated. The results show that exporting firms adjust product quality to the forward exchange rate to optimize global profits. With this theoretical background an empirical study is conducted on the imports and exports of manufactured goods between the United States and India between 1989 and 2001. Data from the US customs at the 10 digit HTS code level that are collected by Feenstra et al. (2002) are used. The following 0 H hypothesis is tested: The quality gap between products produced in India and exported to the United States and products produced in the United States and exported to India declines with a depreciation of the Indian Rupee with respect to the US Dollar. The 0 H hypothesis is tested and accepted using panel data regression. The regression shows a significant relation between the exchange rate and the quality gap. The empirical research also provides evidence that the quality gap decreases with a decrease in the GDP per capita gap.