Nonlinear state and shock dependence of exchange rate pass through on prices

Summary

Focus

This paper examines whether movements in exchange rates are transmitted (or "pass through") to a country's prices in full, and whether the relationship between the exchange rate and prices is linear and stable over time. The paper uses monthly data from a small open economy and a smooth transition auto-regressive vector model estimated by Bayesian methods.

Contribution

In previous studies, as well as in policy analysis, it is often assumed that the pass-through of exchange rates into prices does not change over time. Our study shows that, on the contrary, the pass-through does vary over time and documents its characteristics and the factors that affect its behaviour. An important implication is that models used by central banks for monetary policy decisions should take these characteristics of the pass-through into account.

Findings

Two key findings may be highlighted: (1) a shock to exchange rates does not pass through completely into prices, even in the case of import prices; and (2) the pass-through will vary depending on the state of the economy and the type of shock affecting the economy and the exchange rate.

Abstract

This paper examines the nature of the pass-through of exchange rate shocks on prices along the distribution chain, and estimates its short and long-term path. It uses monthly data from a small open economy and a smooth transition auto-regressive vector model estimated by Bayesian methods. The main finding is that exchange rate pass-through is nonlinear and state and shock dependent. There are two main policy implications of these findings. First, models used by central banks for policymaking should take into account the nonlinear and endogenous nature of the pass-through. Second, a specific rule on pass-through for monetary policy decisions should be avoided.

JEL classification: F31, E31, E52, C51, C52

Keywords: exchange rate pass-through to prices, pricing along the distribution chain, statedependent, shock-dependent, LST-VAR, Bayesian estimation