The role of inflation regime in the exchange rate pass-through to import prices

We examine exchange rate pass-through (ERPT) into aggregate import prices for nine OECD countries in view of Taylor's [Taylor, J., (2000). Low Inflation, Pass-through, and the Pricing Power of Firms, European Economic Review 44 (7), 1389–1408] suggestion that the degree of pass-through is dependent on the importing country inflation regime. Extending the standard mark-up pricing model under monopolistic competition to a setting where the pricing decision is dependent on the importing country inflation experience, we present strong empirical evidence for the inflation regime dependence of pass-through elasticities for the analyzed countries based on nonlinear estimation methodology. Our main result is that the pass-through is highly incomplete and positively correlated with the importing country inflation environment, when the empirical analysis is conducted using nonlinear threshold or smooth transition estimation techniques.