Exchange Rate Pass-Through to Domestic Prices: Evidence from VECM

Inflation, exchange rate and gross domestic product (GDP) are critical variables to macroeconomic stability. For a small economy like Zambia, it is imperative for central authorities to establish the size and degree of the exchange rate pass-through (ERPT) to domestic prices and output as they formulate monetary policies. This paper examines the effect of ERPT to domestic prices and local production using the vector error correction model (VECM) for the period 1995Q1 to 2019Q4. The study utilizes the baseline and alternative models for intra study comparisons. Results show that the ERPT to domestic prices is high, persistent, and incomplete in the baseline model while the alternative model depicts a low, persistent, and incomplete ERPT in the long run. Furthermore, the long run ERPT to local production was found to be high, persistent, and complete. Policy implications are that monetary and fiscal policies should be geared towards exchange rate measures that would contribute to both internal and external balances and nurture macroeconomic stability. The measures would include management of exchange rate volatility, effective debt sustainability strategies and reviving as well as broadening the manufacturing sector in Zambia to nurture an export-oriented economy.