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

48 Pages Posted: 6 Jul 2018

See all articles by Kristin J. Forbes

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

London Business School - Department of Economics

Multiple version iconThere are 4 versions of this paper

Date Written: June 2018

Abstract

A major challenge for monetary policy is predicting how exchange rate movements will impact inflation. We propose a new focus: directly incorporating the underlying shocks that cause exchange rate fluctuations when evaluating how these fluctuations “pass through” to import and consumer prices. A standard open-economy model shows that the relationship between exchange rates and prices depends on the shocks which cause the exchange rate to move. We build on this to develop a structural Vector Autoregression (SVAR) framework for a small open economy and apply it to the UK. We show that prices respond differently to exchange rate movements based on what caused the movements. For example, exchange rate pass-through is low in response to domestic demand shocks and relatively high in response to domestic monetary policy shocks. This framework can improve our ability to estimate how pass-through can change over short periods of time. For example, it can explain why sterling’s post-crisis depreciation caused a sharper increase in prices than expected, while the effect of sterling’s 2013-15 appreciation was more muted. We also apply this framework to forecast the extent of pass-through from sterling’s sharp depreciation corresponding to the UK’s vote to leave the European Union.

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Suggested Citation

Forbes, Kristin J. and Hjortsoe, Ida Maria and Nenova, Tsvetelina, The Shocks Matter: Improving Our Estimates of Exchange Rate Pass-Through (June 2018). NBER Working Paper No. w24773. Available at SSRN: https://ssrn.com/abstract=3206448

Kristin J. Forbes (Contact Author)

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

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

National Bureau of Economic Research (NBER)

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Ida Maria Hjortsoe

Bank of England ( email )

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London, EC2R 8AH
United Kingdom

Tsvetelina Nenova

London Business School - Department of Economics ( email )

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Regent's Park
London NW1 4SA
United Kingdom

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