The shocks matter: Improving our estimates of exchange rate pass-through

Abstract

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.

Has the Exchange Rate Pass‐Through changed in South Africa?

“…This is consistent with a recent study by Forbes et al. () who find that ERPT depends to a large extent on the source of the exchange rate movement. They argue that global supply and demand shocks, monetary policy shock and domestic supply and demand shocks play a considerable role in explaining the PT to import prices.…”

“…(), Gopinath (), Forbes et al. () have used equation to estimate the first‐stage ERPT for South Korea and Thailand, industrial countries, Singapore, a panel of AEs and EMEs, and the United Kingdom, respectively. In addition, the consensus literature points to the time‐varying nature of the ERPT .…”

Exchange Rate and Inflation Dynamics in a Resource Rich Setting: The Case of Zambia

“…Third, we analyse whether there is a differential ERPT depending on the shock that drives the exchange rate fluctuation, following Forbes et al . (). We further investigate whether and to what extent food and non‐food inflation are affected differently, and also report differential ERPTs obtained using the respective disaggregated CPIs.…”

Exchange rate uncertainty and import prices in the euro area

“…However, there appears to be disagreement across the ERPT estimates. Country‐specific factors, as well as problems with misspecification and the suboptimality of proxies for important determinants have been given as a reason why this might be the case (Corsetti et al, ; De Bandt et al, ; Forbes, Hjortsoe, & Nenova, ; Goldberg & Knetter, ; Osbat & Wagner, ). More recent studies have suggested that the ERPT is time varying and that it is higher during periods of macroeconomic instability (De Bandt & Razafindrabe, ; Donayre & Panovska, ; Nogueira & León‐Ledesma, ).…”

“… As pointed out by Forbes et al (), the exchange rate is in most part a purely endogenous variable, which is driven by supply and demand shocks. In that respect our model is much closer to the earlier literature on ERPT. …”