Shocks versus Structure: Explaining Differences in Exchange Rate Pass-Through across Countries and Time

Abstract

We show that exchange rate pass-through to consumer prices varies not only across countries, but also over time. Previous literature has highlighted the role of an economy’s ‘structure’ — such as its inflation volatility, inflation rate, use of foreign currency invoicing, and openness — in explaining these variations in pass-through. We use a sample of 26 advanced and emerging economies to show which of these structural variables are significant in explaining not only differences in pass-through across countries, but also over time. The ‘shocks’ leading to exchange rate movements can also explain variations in pass-through over time. For example, exchange rate movements caused by monetary policy shocks consistently correspond to significantly higher estimates of pass-through than those caused by demand shocks. The role of ‘shocks’ in driving pass-through over time can be as large as that of structural variables, and even larger for some countries. As a result, forecasts predicting how a given exchange rate movement will impact inflation at a specific point in time should take into account not just an economy’s ‘structure’, but also the ‘shocks’.

Keywords: Pass-Through, Exchange Rate, Price Level, Inflation, Monetary Policy

JEL Classification: E31, E37, E52, F47