Price Setting and Exchange Rate Pass-Through: Theory and Evidence

Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 22/2002

Price Adjustment and Monetary Policy, Bank of Canada, 2003 (Online available http://www.bankofcanada.ca/en/topic/top-exc.html)

25 Pages Posted: 28 Aug 2007 Last revised: 26 Jul 2022

Date Written: December 1, 2002

Abstract

This working paper was written by Michael B. Devereux (University of British Columbia and CEPR) and James Yetman (University of Hong Kong).

There has been a considerable recent debate on the causes of low pass-through from exchange rates to consumer prices. This paper develops a simple model of a small open economy in which exchange rate pass-through is determined by the frequency of price changes of importing firms. But this, in turn, is determined by the monetary policy rule of the central bank. 'Looser' monetary policy, which implies a higher mean inflation rate, and a higher volatility of the exchange rate, will lead to more frequent price changes and a higher rate of pass-through. The model implies that there should be a positive, but nonlinear, relationship between pass-through and mean inflation, and a positive relationship between passthrough and exchange rate volatility. In a sample of 122 countries, this is strongly supported by the data. Our conclusion is that, at least partly, low exchange rate pass-through is a result of short-term price rigidities.

Suggested Citation

Institute for Monetary and Financial Research, Hong Kong, Price Setting and Exchange Rate Pass-Through: Theory and Evidence (December 1, 2002). Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 22/2002, Price Adjustment and Monetary Policy, Bank of Canada, 2003 (Online available http://www.bankofcanada.ca/en/topic/top-exc.html), Available at SSRN: https://ssrn.com/abstract=1009466

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