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

Kristin Forbes, Ida Hjortsoe and Tsvetelina Nenova

No 13037, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: consumer prices; exchange rate pass-through; import prices; inflation; vector autoregressions (search for similar items in EconPapers)
JEL-codes: E31 F3 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac, nep-mon and nep-opm
Date: 2018-07
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Related works:
Journal Article: The shocks matter: Improving our estimates of exchange rate pass-through (2018) Downloads
Working Paper: The Shocks Matter: Improving Our Estimates of Exchange Rate Pass-Through (2018) Downloads
Working Paper: The shocks matter: improving our estimates of exchange rate pass-through (2015) Downloads
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