Authors: Rebecca Hellerstein and Sofia Berto Villas-Boas

A growing share of international trade occurs through intra-firm transactions—those between domestic and foreign subsidiaries of a multinational firm. The difficulties associated with writing and enforcing a vertical contract compound when a product must cross a national border, and may explain the high rate of multinational trade across such borders. We show that this common cross-border organization of the firm may have implications for the well-documented incomplete transmission of shocks across borders. We present new evidence of a positive relationship between an industry’s share of multinational trade and its rate of exchange rate pass-through to prices. We then develop a structural econometric model with both final assemblers and upstream parts suppliers to quantify how firms’ organization of their activities across national borders affects their pass-through of a foreign cost shock. We apply the model to data from the auto market. Counterfactual experiments show why cross-border transmission may be higher for a multinational transaction than an outsourced transaction. In the structural model, firms’ pass-through of foreign cost shocks to intermediate inputs is on average 12 percentage points lower, given a one-standard-deviation increase in the share of value added that is produced through outsourced, rather than in-house, production. The higher markups from two optimizations along the supply chain create an additional opportunity for markup adjustment following a shock.