Price Inflation and Exchange Rate Pass-Through in Chile
A price equation based on a model of imperfect competition was estimated using quarterly data for Chile from 1986:1 to 2001:1. The estimation includes the first difference of the dependent variable following the literature on the estimation of linear quadratic adjustment cost (LQAC) models, when the target and some of the driving variables follow I(2) processes. The equation is used to generate out-of-sample inflation forecast, of a narrower-than the-CPI price index. We can conclude from the estimation results: i) exchange-rate pass-through depends positively on economic activity (output gap) explaining why pass-through has been so low in recent years in Chile. In other words, a negative output gap has compensated the inflationary impact of exchange-rate depreciation; ii) productivity reduces unit labor costs and inflation; iii) wages and foreign prices are positively related to inflation; iv) Finally, expected inflation acceleration is significant, confirming that expectations matter determining inflation.
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