Exchange Rate Pass-Through and Domestic Inflation: A Comparison between East Asia and Latin American Countries
Takatoshi Ito () and
Discussion papers from Research Institute of Economy, Trade and Industry (RIETI)
Currency crises, accompanied by large devaluation, tend to have significant impacts on the domestic economy. If the exchange rate also depreciates in real terms, the economy can take advantage of the export price competitiveness to promote its exports. In contrast, if the currency devaluation induces an increase in domestic inflation, the currency value in real terms will return toward the pre-crisis level, which results in a loss of the export price competitiveness and, hence, a slow recovery from the severe economic downturn. This paper analyzes the degree of domestic price responses to the exchange rate changes in crisis-hit countries in East Asian and Latina American countries and Turkey in order to reveal why the post-crisis inflation performance was very different across countries. The structural vector autoregression (VAR) technique is applied to examining exchange rate pass-through. The degree of exchange rate pass-through is found to be higher in Latin American countries and Turkey than in East Asian countries with a notable exception of Indonesia. In particular, Indonesia, Mexico, Turkey and, to a lesser extent, Argentina show a strong response of CPI to the exchange rate shock. More noteworthy is that excessive supply of base money played an important role in increasing the domestic inflation rate in Indonesia, while such effect is not observed in other countries, which indicates the importance of credible monetary policy committed to price stability in order to prevent the post-crisis inflation. Shock transmission from import prices or PPI to CPI is quite large in Indonesia, Mexico and Turkey. This finding implies that the channel of shocks at different stage of pricing chain may be an additional factor in high domestic inflation.
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