The Effect of Exchange Rate on Inflation

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THE EFFECTS OF EXCHANGE RATE IN INFLATION OUTPUT AND THE CURRENT ACCOUNT

ABSTRACT

The empirical studies on the effects of changes in exchange rates on inflation and real activity can be broadly divided into four categories:
Single-equation econometric methods,
Vector autoregressive (VAR) models,
Structural macro econometric models and DSGE models - Dynamic stochastic general equilibrium.

Methodologies:
First, most participants use single-equation econometric methods that estimate an exchange rate pass-through equation. The Bank of Israel, for example, estimates an open-economy version of a New Keynesian Phillips curve proposed by Svensson (2000), which relates inflation to expected inflation, the output gap, the exchange rate and import prices Bank of Israel summaries research at the Bank of Canada that typically used a Phillips curve to examine the impact of exchange rate movements on consumer prices. While most studies estimate pass-through equations with aggregated data, some recent papers also look at sectoral data, following the recent literature that has highlighted heterogeneous responses to exchange rate shocks across sectors. At the Bank of Italy, Bugamelli and Tedeschi (2004) estimate panel regressions with sectoral data. Several papers also estimate pass through for a panel of countries, example that by Bailliu and Fuji (2004) at the Bank of Canada. This line of research has produced a number of papers on euro-area countries. Some empirical studies have also focused on emerging market countries. Secondly, a number of papers use variants of the VAR models. Hahn (European Central Bank (2003)) estimates a VAR model with quarterly data to analyse the effect of exogenous shocks along the pricing chain. Kapur (Reserve Bank of India (2004)) estimates the impact of exchange rate changes in India using a small VAR with short-run restrictions. Work conducted at the Central Bank of Brazil also uses VAR techniques to trace the dynamic effect



References: 1. Alves S, M Muinhos and G Riella (2002): “Modelo estrutural com setor externo: endogeneização do prêmio de risco e do câmbio”, Central Bank of Brazil Working Paper, no 42, June. 2 3. Bank of Canada (2003): Intervention in the foreign exchange market, October, http://www.bankofcanada.ca/en/backgrounders/bg-e2.htm. 4 5. Bergin, P (2003): “Putting the ‘New Open Economy Macroeconomics’ to a Test”, Journal of International Economics, vol 60(1), pp 3–34, May. 6. BIS (1999): Estimating and interpreting probability density functions, proceedings of the workshop held at the BIS on 14 June 1999. 7. Borio, C (1997): “The implementation of monetary policy in industrial countries: a survey”, BIS Economic Papers, no 47. 8 9. Bufman, G and L Leiderman (2001): “Surprises on Israel’s road to exchange rate flexibility”, Emerging Markets Research, Deutsche Bundesbank, 23 March. 10 11. Buisán, A and J C Caballero (2003): “Análisis comparado de la demanda de exportación de manufacturas en los países de la UEM”, Bank of Spain Working Paper, no 0322. 12. Buisán, A, J C Caballero and N Jiménez (2004): “Determinación de las exportaciones de manufacturas en los países de la UEM a partir de un modelo de oferta-demanda", Bank of Spain Working Paper, no 0406. 13 14. Campa, J M and L S Goldberg (2002): “Exchange Rate Pass-Through into Import Prices: A Macro or Micro Phenomenon?”, Federal Reserve Bank of New York Staff Report, no 149, May. 15 16. D’Souza, C (2001): “A Market Microstructure Analysis of FX Intervention in Canada”, Bank of Canada Working Paper, March. 17. Égert, B and L Halpern (2005): “Equilibrium Exchange Rates in Central and Eastern Europe: A MetaRegression Analysis”, CEPR Discussion Paper, 4869. 18 19. Estrada, A, J L Fernández, E Moral and A V Regil (2004): "A quarterly macroeconometric model of the Spanish Economy", Bank of Spain Working Paper, no 0413.

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