The Shocks Matter: Improving Our Estimates of Exchange Rate Pass-Through

56 Pages Posted: 18 Nov 2015  

Kristin J. Forbes

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Ida Hjortsoe

Bank of England

Tsvetelina Nenova

Bank of England

Multiple version iconThere are 2 versions of this paper

Date Written: November 11, 2015

Abstract

A major challenge for monetary policy has been predicting how exchange rate movements will impact inflation. We propose a new focus: incorporating the underlying shocks that cause exchange rate fluctuations when evaluating how these fluctuations “pass-through” into import and consumer prices. We show that in a standard open-economy model the relationship between exchange rates and prices depends on the shocks which cause the exchange rate to move. Then we develop an SVAR framework for a small open economy that relies on both short-run and long-run identification restrictions consistent with our theoretical model. Applying this framework to the UK, we find that the response of both import and consumer prices to exchange rate fluctuations depends on what caused the fluctuations. For example, exchange rate pass-through is relatively large in response to domestic monetary policy shocks, but smaller in response to domestic demand shocks. This framework helps explain why pass-through can change over time, including why sterling’s post-crisis depreciation caused a sharper increase in prices than expected and sterling’s recent appreciation has had a more muted effect.

Keywords: Exchange rate pass-through, import prices, consumer prices, inflation, vector autogression

JEL Classification: E31, F3, F41

Suggested Citation

Forbes, Kristin J. and Hjortsoe, Ida and Nenova, Tsvetelina, The Shocks Matter: Improving Our Estimates of Exchange Rate Pass-Through (November 11, 2015). MIT Sloan Research Paper No. 5149-15. Available at SSRN: https://ssrn.com/abstract=2691512 or http://dx.doi.org/10.2139/ssrn.2691512

Kristin J. Forbes (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

Room E62-416
Cambridge, MA 02142
United States
617-253-8996 (Phone)

HOME PAGE: http://web.mit.edu/kjforbes/www

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Ida Maria Hjortsoe

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Tsvetelina Nenova

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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