Conditional Exchange Rate Pass-Through: Evidence from Sweden

Abstract

The pass-through from exchange rate changes to inflation differs depending on the underlying shock. This paper quantifies the conditional exchange rate pass-through (CERPT) to prices, i.e. the change in prices relative to that in the exchange rate following a certain exogenous shock, with a structural econometric approach using data for Sweden, a small economy that is very open to trade. We find that the pass-through to consumer prices following an exogenous exchange rate shock is rather small. Importantly, this shock is not the most important driver of exchange rate fluctuations, unlike what standard structural macroeconomic models would indicate. For Sweden, the CERPT is negative not only for domestic but also for global demand shocks. The estimated combination of shocks with positive and negative CERPT implies that the average pass-through to consumer prices is roughly zero.

Shock-Dependent Exchange Rate Pass-Through: Evidence Based on a Narrative Sign Approach

“…] First, the narrative-sign-identified exchange rate shock contributes more to the exchange rate movement than the counterpart identified by the traditional approach. Similar to Forbes et al (2018b), Comunale and Kunovac (2017) and Corbo et al (2018), we find that the traditional exchange rate shock only explains around 25% of the variation in the exchange rate over the horizons while other shocks, especially the supply shock and the demand shock, account for the majority of the variation. This sharply contrasts with the variance decomposition obtained using the narrative sign restrictions, in which the exogenous exchange rate shock accounts for 70% at the one-month horizon and 60% over the long run; the supply shock and the demand shock each account for around 10%.…”

“…A recent strand of the ERPT literature, pioneered by Shambaugh (2008) and Forbes et al (2018a), shows with a structural vector autoregression (SVAR) model that ERPT is shock-dependent, with the extent of ERPT depending on the types of exogenous shocks that trigger the exchange rate movements. This finding is subsequently confirmed by studies such as Borensztein and Queijo Von Heideken (2016) for six South American countries, Comunale and Kunovac (2017) for the euro area, Corbo et al (2018) for Sweden, Forbes et al (2018b) for twenty-six advanced economies, Comunale (2019) for three Baltic states and Ha et al (2019) for a collection of forty-seven countries around the world.…”

“…4 The detrended policy rate can be interpreted as the interest rate gap which signifies the stance of monetary policy. We employ a lag length of six months following An and Wang (2012), Corbo et al (2018) and Forbes et al (2018a). A i is a 6 × 6 coefficient matrix of parameters for i = 1, 2, ......6, while A 0 is an invertible impact matrix which defines the contemporaneous structural relationship among the endogenous variables.…”

“…Forbes et al (2018a) is one of the first attempts to study ERPT with a combination of traditional sign and zero restrictions for the U.K. A few other studies follow this strand of literature with somewhat different SVAR models and impose different combinations of zero and traditional sign restrictions (e.g., Comunale and Kunovac (2017) for the euro area, Corbo et al (2018) for Sweden, and Forbes et al (2018b) for 26 diverse economies). The advantage of the traditional sign restriction approach lies in the fact that it imposes minimalist restrictions which are generally weaker than other earlier identification approaches and are typically uncontroversial among most economists.…”

International Evidence on Shock-Dependent Exchange Rate Pass-Through

“…The limited number of papers that have made some attempt to model the underlying shocks include: Shambaugh (2008), which was the first paper to identify a set of shocks to exchange rates for several countries through long-run restrictions, and more recently , which develops a more extensive SVAR framework to study shock-dependent exchange rate pass-through in the UK. 2 Comunale and Kunovac (2017) and Corbo and Di Casola (2018) also apply this latter SVAR framework to selected euro area economies and Sweden, respectively. These SVAR studies all find evidence for the specific country (or region) on which they focus, supporting theoretical work that a given exchange rate movement can be associated with very different price dynamics depending on the underlying shock.…”