Explaining the Exchange Rate Pass-Through in Hungary: Simulations with the NIGEM Model

This paper explores the major determinants of the exchange rate pass-through to CPI. The simulations were performed with the Bank's estimated Hungarian block linked to the NIGEM model of the National Institute of Economic and Social Research (NIESR). The modelling framework offers some insight into the role of different markets in the price-exchange rate relationship. The paper gives an analysis of the relative importance of expectations, goods and labour market parameters. Our results show that the contribution of goods and labour market parameters to explaining the economy-wide exchange rate pass-through changes over time. While goods market adjustment is significant from the start of an exchange rate shock, the labour market starts to gain importance only from year three and onwards. More specifically, the effect of mark-up adjustment prevails over the whole horizon, which indicates that it is the most significant channel in exchange rate pass-through. The slow appearance of labour market effects might be explained by the presence of nominal wage rigidities, which make the adjustment in quantities faster. These results may explain the current labour market behaviour seen after the introduction of the inflation-targeting regime in Hungary. Hence we argue that the exchange rate shock in 2001 is still too close in time to draw conclusions on the role of labour market rigidities in Hungary.