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Does the exchange rate pass-through into prices change when inflation targeting is adopted? The Peruvian case study between 1994 and 2007

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  • Maertens Odria, Luís Ricardo
  • Castillo, Paul
  • Rodriguez, Gabriel

Abstract

This paper analyzes whether the exchange rate pass-through into prices changed when the inflation targeting scheme was adopted in Peru. First, a simple dynamic stochastic general equilibrium model is simulated, which shows that adopting this scheme induces an increase in exchange rate volatility. Furthermore, applying the theory of the currency denomination of international trade, it is demonstrated that increased exchange rate volatility reduces the share of firms that set their prices in foreign currency. Given that the pass-though has a direct relationship with this share, it is shown that adopting inflation targeting generates a pass-through contraction. Second, we empirically test whether the Peruvian Central Bank’s decision to adopt inflation targeting in January 2002 actually had an effect on the pass-through estimating a time-varying vector autoregressive model which allows for an asymmetrical estimation of the pass-through. It provides parameters for both the pre and post inflation targeting regimes based on the assumption that the transition from one regime to the other is smooth. An analysis of the generalized impulse response functions reveals that the decision to adopt inflation targeting significantly decreased the exchange rate pass-throughs into import, producer, and consumer prices. The results are consistent with economic theory and are robust to the specification of parameters of the model.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Macroeconomics.

Volume (Year): 34 (2012)
Issue (Month): 4 ()
Pages: 1154-1166

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Handle: RePEc:eee:jmacro:v:34:y:2012:i:4:p:1154-1166

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Web page: http://www.elsevier.com/locate/inca/622617

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Keywords: Inflation targeting; Exchange rate pass-through into prices; TV-VAR models;

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Cited by:
  1. Pierre-Richard Agénor & Luiz A. Pereira da Silva, 2013. "Inflation Targeting and Financial Stability: A Perspective from the Developing World," Working Papers Series 324, Central Bank of Brazil, Research Department.
  2. Winkelried, Diego, 2012. "Traspaso del tipo de cambio y metas de inflación en el Perú," Revista Estudios Económicos, Banco Central de Reserva del Perú, issue 23, pages 9-24.

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