11.3 Exchange Rate Pass-through and Monetary Policy

Exchange rate pass-through is crucial in monetary policy. It measures how exchange rate changes affect domestic prices of imports. The degree of pass-through impacts how well central banks can control inflation and influence the economy through policy decisions.

Understanding pass-through helps policymakers navigate trade-offs. High pass-through means exchange rate changes strongly affect inflation, complicating price stability goals. Low pass-through gives central banks more flexibility to focus on domestic objectives without worrying as much about currency fluctuations.

Exchange Rate Pass-Through

Definition and Relevance

Top images from around the web for Definition and Relevance

• 

  Monetary Policy and Economic Outcomes | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

• 

  Monetary Policy and Economic Outcomes | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  Monetary Policy and Economic Outcomes | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

1 of 3

Top images from around the web for Definition and Relevance

• 

  Monetary Policy and Economic Outcomes | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

• 

  Monetary Policy and Economic Outcomes | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  Monetary Policy and Economic Outcomes | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

1 of 3

• Exchange rate pass-through measures how changes in the exchange rate impact domestic prices of imported goods and services
• The degree of exchange rate pass-through significantly affects the effectiveness of monetary policy in achieving price stability and influencing domestic economic conditions
• Higher exchange rate pass-through means changes in the exchange rate have a more substantial impact on domestic inflation, while lower pass-through indicates a weaker link between exchange rate fluctuations and domestic prices
• The extent of exchange rate pass-through varies across countries (developed vs. emerging economies), sectors (tradable vs. non-tradable goods), and time periods (short-run vs. long-run)
• Understanding the nature and magnitude of exchange rate pass-through is essential for central banks to formulate appropriate monetary policy responses to exchange rate movements

Transmission Mechanism and Implications

• The degree of exchange rate pass-through has significant implications for the transmission of monetary policy shocks to the domestic economy
• In the presence of high exchange rate pass-through, changes in the exchange rate resulting from monetary policy actions have a more pronounced effect on domestic prices and inflation
  • An appreciation of the domestic currency following a contractionary monetary policy shock leads to lower import prices and reduced inflationary pressures (tighter monetary conditions)
  • A depreciation of the currency due to an expansionary monetary policy shock results in higher import prices and increased inflation (looser monetary conditions)
• The impact of exchange rate pass-through on domestic output depends on the net effect of changes in the exchange rate on exports, imports, and domestic demand
  • An appreciation of the currency makes exports less competitive and reduces foreign demand, while making imports cheaper and potentially boosting domestic consumption (expenditure switching effect)
  • The overall effect on output depends on the relative strength of these channels and the specific characteristics of the economy (trade openness, import dependence)
• High exchange rate pass-through complicates the task of monetary policy in achieving price stability, as exchange rate fluctuations have a more direct and immediate impact on domestic prices
• Central banks need to consider the degree of exchange rate pass-through when assessing the appropriate monetary policy stance and the potential trade-offs between price stability and output stabilization

Factors Influencing Pass-Through

Market Structure and Pricing Behavior

• The market structure of the importing country, such as the level of competition and the presence of monopolistic or oligopolistic firms, affects the degree of exchange rate pass-through
• Firms with greater market power have more flexibility in absorbing exchange rate changes and may choose to maintain stable prices to preserve market share, resulting in lower pass-through (pricing to market)
• The pricing behavior of firms, such as the use of local currency pricing (LCP) or producer currency pricing (PCP), influences the extent of exchange rate pass-through
  • LCP involves setting prices in the currency of the importing country, which insulates domestic prices from exchange rate fluctuations and leads to lower pass-through (invoicing in local currency)
  • PCP involves setting prices in the currency of the exporting country, which results in higher pass-through as exchange rate changes are directly transmitted to import prices (invoicing in producer currency)
• The share of imported inputs in domestic production and the degree of substitutability between domestic and foreign goods affect the magnitude of exchange rate pass-through (import content of production)
• The presence of long-term contracts and the frequency of price adjustments by firms influence the speed and extent of pass-through (price stickiness)

Macroeconomic and Structural Factors

• Macroeconomic factors, such as inflation expectations, economic growth, and the credibility of monetary policy, shape the degree of exchange rate pass-through over time
• Countries with a history of high and volatile inflation tend to have higher exchange rate pass-through, as firms and consumers are more sensitive to exchange rate changes (inflation history and expectations)
• Economies with a more diversified production structure and a larger non-tradable sector may experience lower exchange rate pass-through, as the impact of exchange rate fluctuations on overall prices is more limited (economic structure and trade openness)
• The level of economic development and the depth of financial markets can influence the degree of exchange rate pass-through, with more developed economies generally exhibiting lower pass-through (financial market development)
• Structural reforms that enhance competition, reduce trade barriers, and promote price flexibility can affect the degree of exchange rate pass-through over time (structural policies and reforms)

Implications for Monetary Policy

Challenges in Achieving Price Stability

• The presence of high exchange rate pass-through complicates the task of monetary policy in achieving price stability, as exchange rate fluctuations have a more direct and immediate impact on domestic prices
• Central banks may face a trade-off between stabilizing the exchange rate and achieving domestic price stability
  • Attempts to stabilize the exchange rate through interventions or adjustments in monetary policy may conflict with the goal of maintaining low and stable inflation (exchange rate targeting)
  • Focusing solely on domestic price stability may lead to greater exchange rate volatility and potential economic disruptions (inflation targeting)
• Central banks need to carefully assess the costs and benefits of different policy responses to exchange rate movements, considering the specific characteristics of their economies and the degree of exchange rate pass-through

Policy Considerations and Trade-offs

• The effectiveness of monetary policy in managing exchange rate volatility may be limited by the presence of capital flows, speculative activities, and external shocks (global financial conditions)
• Central banks may need to employ a range of tools and policy instruments, such as foreign exchange interventions, macroprudential measures, and communication strategies, to mitigate the impact of exchange rate volatility on the economy (policy toolkit)
• The choice between exchange rate stability and monetary policy autonomy depends on the exchange rate regime and the degree of capital mobility (trilemma of international finance)
• In a flexible exchange rate regime, monetary policy can focus on domestic objectives, while the exchange rate is allowed to adjust in response to economic fundamentals and market forces (floating exchange rates)
• In a fixed exchange rate regime, monetary policy is subordinated to the goal of maintaining the exchange rate peg, limiting the ability to respond to domestic economic conditions (pegged exchange rates)

Managing Exchange Rate Volatility

Policy Responses and Interventions

• Exchange rate volatility poses several challenges for central banks in conducting monetary policy and maintaining macroeconomic stability
• Excessive exchange rate fluctuations create uncertainty and disrupt trade flows (trade disruptions), investment decisions (investment uncertainty), and financial stability (financial market volatility)
• Central banks may intervene in foreign exchange markets to smooth out excessive volatility and prevent disorderly market conditions (foreign exchange interventions)
  • Sterilized interventions involve buying or selling foreign currency while simultaneously conducting offsetting open market operations to maintain the domestic money supply (sterilization)
  • Non-sterilized interventions involve changing the domestic money supply in response to foreign exchange transactions, which can affect domestic monetary conditions (monetary impact)
• Macroprudential measures, such as capital controls and foreign currency reserve requirements, can be used to manage capital flows and mitigate the impact of exchange rate volatility on the financial system (financial stability tools)

International Policy Coordination

• International policy coordination and cooperation among central banks are important in addressing global factors that contribute to exchange rate volatility and its spillover effects across countries
• Central banks may engage in coordinated interventions or joint policy actions to address common challenges and promote global financial stability (policy coordination)
• International forums, such as the G20 and the International Monetary Fund (IMF), provide platforms for policy dialogue, information sharing, and multilateral surveillance of exchange rate policies (multilateral frameworks)
• Adherence to international norms and best practices, such as avoiding competitive devaluations and promoting transparency in exchange rate policies, can help mitigate exchange rate volatility and its adverse effects (international standards and norms)
• Effective communication and forward guidance by central banks can help anchor expectations and reduce uncertainty surrounding exchange rate movements and monetary policy intentions (central bank communication)