School of Economics

2010 Discussion Papers

School of Economics Discussion Paper 10/02
April 2010

Is low inflation really causing the decline in
exchange rate pass-through?

Reginaldo P. Nogueira Júnior, Miguel A. León-Ledesma,
Fundação João Pinheiro, University of Kent.

Abstract:

Recent literature has argued that exchange rate pass-through (ERPT) into domestic inflation has been declining in many countries following a dramatic change in inflation environment during the 1990s. Available empirical results face two central challenges: (i) the evidence on declining ERPT is mostly
based on sample-splitting approaches and hence subject to a degree of arbitrariness; and (ii) the link between a lower ERPT and inflation environment is usually based on simple correlation analysis and hence silent about temporal causality. We address these issues by making use of a state-space model that allows ERPT to be time-varying and dependent on the inflation environment.

We estimate the model for 12 developed and emerging economies and test whether inflation contains significant information about the future evolution of the ERPT. The results reinforce the view of a smooth decline in the impact of exchange rates on domestic inflation, but do not support the hypothesis
that lower inflation precedes this declining ERPT.

JEL Classification: E42, E52, E58, F31, F41

Keywords:Exchange Rate Pass-Through, Inflation, State-space Models, Causality Tests.

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