Exchange Rate Pass Through in to Inflation

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Exchange Rate Pass - through in to Inflation: New Insights in to the Cointegration Relationship from Pakistan

Abstract
Understanding the impact of exchange rate movements on prices is critical from a policy perspective in order to gauge the appropriate monetary policy response to currency movements. This study assesses the extent to which the movements in exchange rate affect domestic consumer prices in Pakistan by analyzing quarterly data from 1982 Q1 to 2010 Q4. The Structural VAR (SVAR) model is used to estimate the exchange rate pass through to inflation in Pakistan. Further, impulse response function and variance decomposition are used to measure the exchange rate pass-through to domestic prices. The major findings of this study are: (i) the exchange rate movements have only a moderate effect on domestic prices, (ii) for consumer prices, ERPT elasticity is around 0.042 in the short run and 0.137 in the long run, (iii) Up to 90 percent of the price level changes are explained by its own shocks in the long run. The study concludes that the effect of an exchange rate shock on domestic prices is quite gradual, taking about 14 quarters to arrive at the full impact. The immediate effect of a structural one standard deviation shock to the exchange rate (which is 0.045 increase, or 4.5 percent appreciation) is about 0.001 (or 0.1 percent) decrease in the price level. This entails an impact elasticity of 0.042. The full effect of this shock, realized after about 14 quarters, is about 0.0062 (or 0.62 percent) decrease in the price level. This implies a dynamic pass-through elasticity of 0.137. The result highlights the importance of other factors that play significant role in the Pakistan’s inflationary process e.g. supply shocks. Keywords: Exchange Rate; Domestic Prices; Cointegration; Structural VAR; Pakistan. Jel Classification Code: C53, E31, F31.

1.Introduction
The effects of exchange rate fluctuations to the domestic inflation have been an issue of concern in contemporaneous economics literature (McCarthy, 2006). Exchange rate stabilization policies have serious consequences on the efficiency of other ex-post macroeconomic policy implementations (Rogoff, 1998). Within the framework of macroeconomic models, the degree of exchange rate pass-through (ERPT) into domestic prices is one of the key elements determining the size of the spill out effects of monetary policy (Shintani et al, 2009). According to Zorzi et al (2007, p.5),

“Understanding the impact of exchange rate movements on prices is critical from a policy perspective in order to gauge the appropriate monetary policy response to currency movements”.

Generally, the exchange rate affects the price of all tradable goods. Specifically, exchange rate fluctuations can affect domestic prices through direct and indirect channels (Sahminan, 2002; Hyder and Shah, 2004). However, the most direct channel for ERPT is the direct short term effect on the imported raw material and imported goods. Generally, currency depreciation result in higher import prices and vice versa for currency appreciation (Jabara, 2009). Further, exchange rate depreciation increases the costs of imported raw material and capital goods which results in the higher prices of domestically produced goods (Sahminan, 2002). The larger the share of imported goods within the CPI basket the larger the exchange rate effect on prices (Restrepo and García, 2001). McCarthy (1999) concludes that the pass-through is to some extent stronger in countries with a larger import share in nine industrialized economies. In case of indirect channel, the exchange rate depreciation affects the net exports which in turn manipulate the domestic prices through the changes in aggregate demand, putting upward pressure on domestic prices (Fjærtoft, 2011). Also, import-competing firms may face competition by the foreign competitors and increase prices in order to maintain profit margins (Hyder and Shah 2004)....
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