The Effect of Exchange Rate on Inflation Assignment

The Effect of Exchange Rate on Inflation Assignment Words: 2057

The Bank of Israel, for example, estimates an pen-economy version of a New Keynesian Phillips curve proposed by Sevenths (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 sector data, following the recent literature that has highlighted heterogeneous responses to exchange rate shocks across sectors.

At the Bank of Italy, Bagatelle and Detested (2004) estimate panel regressions with sector data. Several papers also estimate pass through for a panel of countries, example that by Bilabial 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 VARY models. Hahn (European Central Bank (2003)) estimates a VARY model with quarterly data to analyses the effect of exogenous shocks along the pricing chain.

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Kaput (Reserve Bank of India (2004)) estimates the impact of exchange rate changes in India using a small VARY with short-run restrictions. Work conducted at the Central Bank of Brazil also uses VARY techniques to trace the dynamic effect of exchange rate changes, taking account of the role of administered prices. Renovators?? and Hurting (2004) use a VARY model as a cross-check of their CPM and estimate the impact of exchange rates on output and prices in the Czech Republic.

They follow Melon and Perlman’s (2001) VARY for small open economies with a flexible exchange rate, and use German GAP as an exogenous variable representing foreign demand. The Bank of Korea uses a vector error correction model to analyze the dynamic effects of an exchange rate shock on real GAP in Korea. A third approach relies on structural models developed at the central bank. In most cases, these are large-scale simultaneous equations models. At the European Central Bank, the Area Wide Model and the Link-5 Multi-country model are standard structural macroeconomic models.

In the quarterly macro model used at the Bank of Spain , for example, the pass through is embedded in the equations for import and export deflator, private consumption deflator and private productive investment deflator. The Bank of Italy also relies on its quarterly econometric model (KOMBI) to estimate the effect of changes in the euros effective exchange rate. Holus discusses the use of a small-scale macroeconomic model, the quarterly prediction model, at the Czech National Bank . This model forms the main tool in the Czech National Banks analysis and forecasting.

The CPM embodies New Keynesian features, partly forward-looking agents, and a stylized central bank reaction function. Some central banks, for example the Netherlands Bank, rely on small, micro-founded structural models as the basis for empirical analysis. Fourthly, several central bank studies investigate exchange rate effects using open-economy DOGS models examples include National sank of Belgium. EXCHANGE RATES AND INFLATION: Several main common results emerge from research papers on the pass-through of exchange rate changes to prices.

First, there is evidence that the pass-through has been small and declining over the sass. Bank of Japan, for example, document how short-term pass-through in Japan declined by one third in the sass, while long-term pass-through is now less than half its level in the sass. The decline in pass-through as been associated with greater credibility of monetary policy, and the low and stable inflation environment and lower inflation expectations. As in papers Bank of Italy and Netherlands Bank, financial innovations and hedging against short-term exchange rate risks may also have reduced exchange rate pass-through.

The underlying idea is that improved hedging possibilities allow importers and exporters to ignore shocks that may turn out to be only temporary. Bank of Spain noted that growing integration of the Spanish economy in the European Union has also played a role. A similar conclusion is reached by Netherlands Bank. In emerging market countries, the trend towards the adoption of more flexible exchange rate regime is also found to be important. As the exchange rate becomes more volatile, importers tend to view a change more often as temporary and therefore tend to change prices less frequently.

Secondly, there are apparent sector differences in the magnitude of the pass through coefficients in Bank of Italy. The market structure, and in particular the degree of competitiveness, of different sectors seems to be important to determine the ability of importers to pass through exchange rate movements to retail prices. The pass-through should be larger when the domestic market is relatively easier to access by exporters; this is the case when the entry costs are smaller – as in competitive industries – and the domestic producers are less productive – as in non-industrial countries.

Differences in exchange rate pass- through across exporting countries turn out to be robust and independent of (markets and products) composition effects. This is particularly clear in the case of Italy, whose exporting firms tend to raise export prices in the face of a depreciation of their own currency by about 30 percentage points – of the exchange rate variation – ore than the other main Euro area countries. These differences are a reflection of the existence of a “boundary” effect, for which the location of producers matters.

Thus institutional and structural factors in the exporting country should also be considered as determinants of exchange rate pass-through. Thirdly, changes to the institutional and economic environment also play an important role. As emphasized by work at the Bank of Spain, the creation and expansion of the European Union and the common market has led to more competition and lowered pass-through. However, the Bank of Spain does not find any significant evidence on the possible existence of structural change in the pass through around the starting of the European Monetary Union.

The change in the economic environment is particularly relevant for the accession countries in the European Union. As highlighted by research at the Reserve Bank of India, free trade, lower trade barriers, globalization , driven by fast growth in Asian manufacturing capability, enhances global competition and reduces producers’ pricing power, therefore lowering pass-through to inflation. Fourthly, it is important to understand the transmission mechanisms of exchange rate changes, and in particular the role of the trade and investment channels.

Empirical work conducted by the Central Bank of Chile, for instance, distinguishes the direct import price effect, the relative price effect (expenditure-switching), the intermediate effect (cost of input) and the balance sheet effect (currency mismatch) of exchange rate movements on consumer prices. EXCHANGE RATES AND OUTPUT, PROFITS AND THE CURRENT ACCOUNT: A number of studies have investigated the impact of exchange rates movements on the real economy. Papers by Bank of Spain staff provide evidence of a declining impact.

Some papers provide evidence indicating that a depreciating currency did not always bring about an expansion of output. Bank of Korea finds that the effect of changes in the exchange rate on output seems to have increased since the mid-sass, a result that seems to reflect in part the effect of the currency crisis. Motivated by the growing external imbalance of the United States, several papers have looked at the relationship between exchange rates and the current account. Bank of France perform an econometric analysis using

NIGER, a standard multi-country macroeconomic model, and find that a depreciation of the US dollar against other major currencies alone will do little to correct the US external imbalances. Furthermore, they find that it is the monetary policy reaction to the exchange rate shock, and not the exchange rate shock itself, which may have a (small) impact on the current account. Rather, a combination of (possibly sharp) dollar depreciation, fiscal discipline and monetary tightening in the US is more likely to bring about a correction.

A similar conclusion is reached by the Bank of Italy’s staff sing simulations with their quarterly econometric model (KOMBI). Federal Reserve Board suggested that a substantial change in the value of the dollar is likely to play a key role in a future adjustment of the US external balance. Monetary policy can play an important role in these adjustments. To maintain full employment and price stability, monetary policy would be expected to tighten in economies where a rise in external demand might boost output above potential, and, conversely, to ease in economies where a decline in external demand threatened to leave output below potential.

They also argue that a reduction of the trade imbalances will require substantial changes in resource allocation across sectors for treatable and non- treatable goods, as well as shifts in sector demands. Federal Reserve Bank of New York highlights the role of exchange rate policies followed in Asia. They uses simulations off stochastic general equilibrium model of the global economy to assess the quantitative impact of Asian central banks’ effort to stabilize exchange rates on the prospects for a current account reversal in the United States.

The main effect of the current monetary stance in Asia is found to be a shift of the main ruder of adjustment from exchange rates to aggregate demand in the United States and its main partners. They argue that along with changes in output growth, exchange rate changes have historically played a key role in the adjustment of external imbalances in industrial countries. They show that in terms of the process of adjustment, the 1987 reversal of the US current account deficit shared some features with the episodes in other industrial countries, but also highlighted some important differences.

Given these, and some additional characteristic of the present encounter, they conclude that it is difficult to use historical patterns of reversals to make inferences about the sustainability of, and possible future reduction in, the US current account deficit. CONCLUSION: One interesting finding is that most methods deliver broadly similar results, indicating that in general and for a variety of reasons, the degree of exchange rate pass-through and the impact of exchange rate changes on the real economy has diminished in the last 10-15 years. This result seems to be robust to different underlying models and econometric techniques employed.

At the same time, several ethological issues have not yet been fully addressed. Bank of Spain and Bank of Israel make a clear distinction between short- and long-run pass-through effects, and argue that while the long-run pass through is almost complete, the extent of short- term pass-through is limited and incomplete. To the extent that the definition of “long run” matters for the empirical results, it is important to improve our ability to distinguish short- and long-run. In one case (Israel), short-term pass-through has actually increased, raising the question of what specific factors there may explain this exception.

Secondly, an issue that has received little attention is the potential asymmetry in exchange rate pass through effects between appreciations and depreciations. Work at the Bank of Italy points out that the pass-through appears to be complete following an appreciation but incomplete after depreciation. This issue is likely to receive more attention from both a theoretical and an empirical point of view. Thirdly, exchange rate movements have effects on inflation but may in turn also be affected by inflation and real variables. Hence, empirical work often relies on he same set of data and variables to test two directions of causality.

In the analysis of the degree of exchange rate pass-through to inflation, price inflation is used as the dependent variable and the exchange rate as an explanatory variable. By contrast, in models of exchange rate determination, movements in exchange rate are explained in terms of inflation and other variables. There is an identification issue here, and may potentially bias estimates. The issue of reverse causality needs to be handled carefully. Fourthly, while most papers focus on the average level of exchange rates, exchange rate volatility may have an impact on inflation and inflation volatility.

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