Exchange rate pass-through and real exchange rate in EU candidate countries

This paper studies a particular aspect of the choice of exchange rate regime by EU candidate countries in the run-up to membership of European Economic and Monetary Union (EMU). The fact that these countries have adopted various exchange rate systems reflects a divergence of opinion on the appropriate way to handle macroeconomics and, in particular, to curb inflation. This paper studies the connection between changes in the exchange rate and inflation as perceived in various exchange rate systems in order to draw conclusions with regard to the possible role of exchange rate management in achieving and maintaining low inflation in these countries. To this end we model price and exchange rate changes simultaneously and incorporate adjustment towards the equilibrium real exchange rate. We use a state-space model and the Kalman filter to infer unobserved variables and time-varying parameters.