Exchange Rate Pass-Through to Domestic Prices in Pakistan

This paper assesses the extent to which the movements in exchange rate affect domestic wholesale and consumer prices in Pakistan by analyzing data from January 1988 to September 2003. The empirical model is a recursive VAR, suggested by McCarthy (2000), incorporating a distribution chain of pricing. Impulse response function and variance decomposition are used to measure the exchange rate pass-through to domestic prices. The major findings of this paper are: (1) the exchange rate movements have only a moderate effect on domestic prices, i.e., exchange rate pass-through is low; (2) the exchange rate pass-through is more stronger in wholesale price index (WPI) relative to consumers price index (CPI); (3) the impact of pass-through on domestic prices spreads over 12 months, however, the effect is mostly felt in the first four months; (4) the exchange rate pass-through to consumer prices have further weakened after the free float of Rupee/Dollar parity in July 2000; (5) within the WPI commodity groups, the exchange rate pass- through is stronger in ‘Fuel & Lighting’ and ‘Manufactures’ groups while in the case of CPI, pass-through is more pronounced in ‘Transport & Communication’ and ‘Fuel & Lighting’ group. Furthermore, the exchange rate pass-through to domestic prices is much stronger in higher inflationary environment during Jan-88 to Dec-97 relative to lower inflationary environment down the road.