A major challenge for monetary policy has been predicting how exchange rate movements will impact inflation. We propose a new focus: incorporating the underlying shocks that cause exchange rate fluctuations when evaluating how these fluctuations 'pass through' into import and consumer prices. We show that in a standard open-economy model the relationship between exchange rates and prices depends on the shocks which cause the exchange rate to move. Then we develop an SVAR framework for a small open economy that relies on both short-run and long-run identification restrictions consistent with our theoretical model. Applying this framework to the United Kingdom, we find that the response of both import and consumer prices to exchange rate fluctuations depends on what caused the fluctuations. For example, exchange rate pass-through is relatively large in response to domestic monetary policy shocks, but smaller in response to domestic demand shocks. This framework helps explain why pass-through can change over time, including why sterling's post-crisis depreciation caused a sharper increase in prices than expected and sterling's recent appreciation has had a more muted effect.Key words: Exchange rate pass-through, import prices, consumer prices, inflation, vector autoregression. This paper proposes a fundamental change in the current framework used to analyse and measure how exchange rate movements affect inflation (i.e., exchange rate pass-through). It suggests that instead of treating exchange rate movements as exogenous when estimating their effect on various economic variables, it is necessary to take a step back and model what caused the exchange rate to move in the first place. An application of this framework to the UK shows that this approach can explain why exchange rate movements have had such different effects at different points in time, including why exchange rate pass-through was surprisingly strong during the crisis and more muted recently. This new modelling framework could substantially improve our ability to predict the effects of exchange rate movements on variables such as inflation, thus improving policymakers' ability to conduct monetary policy in the future.It is somewhat surprising that this approach of considering why an exchange rate moves before evaluating its impact has not yet been widely adopted. There is an extensive academic literature on the different causes of exchange rate movements, and a general appreciation that exchange rates are endogenous variables. 2 There is also an extensive literature showing that firms adjust their prices and mark-ups differently after different shocks, based on factors such as how those shocks affect their current and future marginal costs, potential competitors' prices, and demand conditions. 3 For all of these reasons, the pass-through from exchange rate movements to prices may be shock-dependent. There has been some discussion that different shocks to the exchange rate could generate different effects on the economy, such as Klein (1990) Rotem...

We show that exchange rate pass-through to consumer prices varies not only across countries, but also over time. Previous literature has highlighted the role of an economy's 'structure' -such as its inflation volatility, inflation rate, use of foreign currency invoicing, and openness -in explaining these variations in pass-through. We use a sample of 26 advanced and emerging economies to show which of these structural variables are significant in explaining not only differences in pass-through across countries, but also over time. The 'shocks' leading to exchange rate movements can also explain variations in pass-through over time. For example, exchange rate movements caused by monetary policy shocks consistently correspond to significantly higher estimates of pass-through than those caused by demand shocks. The role of 'shocks' in driving pass-through over time can be as large as that of structural variables, and even larger for some countries. As a result, forecasts predicting how a given exchange rate movement will impact inflation at a specific point in time should take into account not just an economy's 'structure', but also the 'shocks'.

A major challenge for monetary policy has been predicting how exchange rate movements will impact inflation. We propose a new focus: incorporating the underlying shocks that cause exchange rate fluctuations when evaluating how these fluctuations 'pass through' into import and consumer prices. We show that in a standard open-economy model the relationship between exchange rates and prices depends on the shocks which cause the exchange rate to move. Then we develop an SVAR framework for a small open economy that relies on both short-run and long-run identification restrictions consistent with our theoretical model. Applying this framework to the United Kingdom, we find that the response of both import and consumer prices to exchange rate fluctuations depends on what caused the fluctuations. For example, exchange rate pass-through is relatively large in response to domestic monetary policy shocks, but smaller in response to domestic demand shocks. This framework helps explain why pass-through can change over time, including why sterling's post-crisis depreciation caused a sharper increase in prices than expected and sterling's recent appreciation has had a more muted effect.

A major challenge for monetary policy has been predicting how exchange rate movements will impact inflation. We propose a new focus: incorporating the underlying shocks that cause exchange rate fluctuations when evaluating how these fluctuations 'pass through' into import and consumer prices. We show that in a standard open-economy model the relationship between exchange rates and prices depends on the shocks which cause the exchange rate to move. Then we develop an SVAR framework for a small open economy that relies on both short-run and long-run identification restrictions consistent with our theoretical model. Applying this framework to the United Kingdom, we find that the response of both import and consumer prices to exchange rate fluctuations depends on what caused the fluctuations. For example, exchange rate pass-through is relatively large in response to domestic monetary policy shocks, but smaller in response to domestic demand shocks. This framework helps explain why pass-through can change over time, including why sterling's post-crisis depreciation caused a sharper increase in prices than expected and sterling's recent appreciation has had a more muted effect.

A major challenge for monetary policy has been predicting how exchange rate movements will impact inflation. We propose a new focus: incorporating the underlying shocks that cause exchange rate fluctuations when evaluating how these fluctuations 'pass through' into import and consumer prices. We show that in a standard open-economy model the relationship between exchange rates and prices depends on the shocks which cause the exchange rate to move. Then we develop an SVAR framework for a small open economy that relies on both short-run and long-run identification restrictions consistent with our theoretical model. Applying this framework to the United Kingdom, we find that the response of both import and consumer prices to exchange rate fluctuations depends on what caused the fluctuations. For example, exchange rate pass-through is relatively large in response to domestic monetary policy shocks, but smaller in response to domestic demand shocks. This framework helps explain why pass-through can change over time, including why sterling's post-crisis depreciation caused a sharper increase in prices than expected and sterling's recent appreciation has had a more muted effect.Key words: Exchange rate pass-through, import prices, consumer prices, inflation, vector autoregression. This paper proposes a fundamental change in the current framework used to analyse and measure how exchange rate movements affect inflation (i.e., exchange rate pass-through). It suggests that instead of treating exchange rate movements as exogenous when estimating their effect on various economic variables, it is necessary to take a step back and model what caused the exchange rate to move in the first place. An application of this framework to the UK shows that this approach can explain why exchange rate movements have had such different effects at different points in time, including why exchange rate pass-through was surprisingly strong during the crisis and more muted recently. This new modelling framework could substantially improve our ability to predict the effects of exchange rate movements on variables such as inflation, thus improving policymakers' ability to conduct monetary policy in the future.It is somewhat surprising that this approach of considering why an exchange rate moves before evaluating its impact has not yet been widely adopted. There is an extensive academic literature on the different causes of exchange rate movements, and a general appreciation that exchange rates are endogenous variables. 2 There is also an extensive literature showing that firms adjust their prices and mark-ups differently after different shocks, based on factors such as how those shocks affect their current and future marginal costs, potential competitors' prices, and demand conditions. 3 For all of these reasons, the pass-through from exchange rate movements to prices may be shock-dependent. There has been some discussion that different shocks to the exchange rate could generate different effects on the economy, such as Klein (1990) Rotem...