Exchange Rate Pass-through and Monetary Policy: How Strong is the Link?
AbstractSeveral authors have presented reduced-form evidence suggesting that the degree of exchange rate pass-through to the consumer price index has declined in Canada since the early 1980s and is currently close to zero. Taylor (2000) suggests that this phenomenon, which has been observed for several other countries, may be due to a change in the behaviour of inflation. Specifically, moving from a high to a low-inflation environment has reduced the expected persistence of cost changes and, by consequence, the degree of pass-through to prices. This paper extends his argument, suggesting that this change in persistence is due to a change in the parameters of the central bank's policy rule. Evidence is presented for Canada indicating that policy has responded more aggressively to inflation deviations over the low pass-through period relative to the high pass-through period. We test the quantitative importance of this change in policy for exchange rate pass-through by varying the parameters of a simple monetary policy rule embedded in an open economy, dynamic stochastic general equilibrium model. Results suggest that increases in the aggressiveness of policy consistent with that observed for Canada are sufficient to effectively eliminate measured pass-through. However, this conclusion depends critically on the inclusion of price-mark-up shocks in the model. When these are excluded, a more modest decline to pass-through is predicted.
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Bibliographic InfoPaper provided by Bank of Canada in its series Working Papers with number 09-29.
Length: 32 pages
Date of creation: 2009
Date of revision:
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Exchange rates; Transmission of monetary policy;
Find related papers by JEL classification:
- F31 - International Economics - - International Finance - - - Foreign Exchange
- F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-10-24 (All new papers)
- NEP-CBA-2009-10-24 (Central Banking)
- NEP-IFN-2009-10-24 (International Finance)
- NEP-MON-2009-10-24 (Monetary Economics)
- NEP-OPM-2009-10-24 (Open Economy Macroeconomics)
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- Ronald H. Lange, 2013. "Monetary policy reactions and the exchange rate: a regime-switching structural VAR for Canada," International Review of Applied Economics, Taylor & Francis Journals, vol. 27(5), pages 612-632, September.
- Mikael Khan & Louis Morel & Patrick Sabourin, 2013. "The Common Component of CPI: An Alternative Measure of Underlying Inflation for Canada," Working Papers 13-35, Bank of Canada.
- Augusto de la Torre & Eduardo Levy Yeyati & Samuel Pienknagura, . "Latin America’s Deceleration and the Exchange Rate Buffer : LAC Semiannual Report, October 2013," World Bank Other Operational Studies 16107, The World Bank.
- Rhys Mendes, 2013. "Understanding commodity price cycles in emerging Asia and their implications for monetary policy," BIS Papers chapters, in: Bank for International Settlements (ed.), Globalisation and inflation dynamics in Asia and the Pacific, volume 70, pages 67-69 Bank for International Settlements.
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