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Exchange Rate Shocks and Inflation Co-movement in the Euro Area

Danilo Leiva-Leon (), Jaime Martinez-Martin () and Eva Ortega
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Eva Ortega: Banco de España

International Journal of Central Banking, 2022, vol. 18, issue 1, 239-275

Abstract: This paper decomposes the time-varying effect of exogenous exchange rate shocks on euro-area countries' inflation into country-specific (idiosyncratic) and regionwide (common) components. To do so, we propose a flexible empirical framework based on dynamic factor models subject to drifting parameters and exogenous information. We show that exogenous shocks are behind an important share of nominal EUR/USD fluctuations over the recent years. Our main results indicate that headline inflation in euro-area countries has become significantly more affected by exchange rate shocks since the early 2010s. While in the case of headline inflation this increasing sensitivity is solely reliant on the idiosyncratic component, for energy inflation it is based on both idiosyncratic and common components. By contrast, exchange rate shocks do not seem to have a significant impact on the core component of headline inflation.

JEL-codes: C32 E31 F31 F41 (search for similar items in EconPapers)
Date: 2022
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Related works:
Working Paper: Exchange rate shocks and inflation comovement in the euro area (2020) Downloads
Working Paper: Exchange rate shocks and inflation comovement in the euro area (2019) Downloads
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