Impulse Response Functions Analysis: An application to the Exchange Rate Pass-Through in Mexico

The paper aims at analyzing the Exchange Rate Pass-Through mechanism for the Mexican economy and is carried out using STATA under two time series frameworks. The first framework is a recursive structural VAR (SVAR) model which, unlike the traditional VAR model, allows us to impose additional restrictions on the contemporaneous and lagged matrices of coefficients. The second is a VEC approach, which considers the possibility of valid cointegrating relationships and allows to incorporate the deviations from the long run equilibrium (cointegrating equations) as explanatory variables when modeling the short run behavior of the variables. Both frameworks aim at the estimation of impulse-response-functions (IRFs) as a tool to analyze the degree and timing of the effect of exchange rate changes on domestic prices using impulse-response functions (IRFs). The recursive SVAR approach allows us to estimate the structural IRFs while the VEC approach uses the Cholesky decomposition of the white noise variance-covariance matrix by imposing some necessary restrictions so that causal interpretation of the simple IRFs is possible. If cointegration exists, estimation of the IRFs provides a tool to identify when the effect of a shock to the exchange rate is transitory and when is permanent.