The Shocks Matter: Improving Our Estimates of Exchange Rate Pass-Through / Kristin Forbes, Ida Hjortsoe, Tsvetelina Nenova.

Format:

Book

Author/Creator:

Forbes, Kristin.

Contributor:

National Bureau of Economic Research.

Hjortsoe, Ida.

Nenova, Tsvetelina.

Series:

Working Paper Series (National Bureau of Economic Research) no. w24773.

NBER working paper series no. w24773

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Other Title:

Shocks Matter

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2018.

Summary:

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.

Notes:

Print version record

June 2018.