Events

Authors:

• James YETMAN
  Institute for Monetary Research

• Michael B. DEVEREUX
  Institute for Monetary Research

There has been a considerable recent debate on the causes of low pass-through from exchange rates to consumer prices. This paper develops a simple model of a small open economy in which exchange rate pass-through is determined by the frequency of price changes of importing firms. But this, in turn, is determined by the monetary policy rule of the central bank. 'Looser' monetary policy, which implies a higher mean inflation rate, and a higher volatility of the exchange rate, will lead to more frequent price changes and a higher rate of pass-through. The model implies that there should be a positive, but non-linear, relationship between pass-through and mean inflation, and a positive relationship between pass-through and exchange rate volatility. In a sample of 118 countries, this is strongly supported by the data. Our conclusion is that, at least partly, low exchange rate pass-through is a result of short-term price rigidities.