# Chapter 5. Inflation and Exchange Rate Pass-Through

Ha, Stocker, and Yilmazkuday motivate their study with a basic observation: monetary policy authorities in EMDEs have long been worried that significant exchange rate fluctuations can jeopardize price stability and force disruptive policy adjustments. As a result, some EMDEs have adopted managed currency arrangements or employ aggressive policy responses to dampen undesirable currency movements—practices motivated by what has been dubbed the “fear of floating” (Calvo and Reinhart 2002). However, the resulting lack of exchange rate flexibility can amplify the impact of external shocks and make it more difficult for a central bank to anchor inflation expectations credibly.

Although large depreciations have become less frequent in EMDEs, they continue to be associated with large increases in inflation. To formulate the appropriate monetary policy response to exchange rate movements, it is essential to assess correctly their impact on inflation. But passthrough ratios—the percentage increase in consumer prices associated with a 1 percent depreciation of the nominal effective exchange rate—are found to vary considerably across countries and over time. Two fundamental factors help to account for these variations: the nature of the shock triggering the currency movement and country characteristics.

To explore these issues in detail, the authors build on the econometric framework developed in Chapter 3, but they focus on the relative responses of inflation and exchange rates to domestic and global shocks. They address three questions:

- How have exchange rate movements affected consumer price inflation over time?

- How does the pass-through to inflation depend on the underlying shock triggering the exchange rate movement?

- What country characteristics are associated with lower pass-throughs?

Their analysis is novel in several dimensions. First, they draw on event studies of large currency movements and analyze shifts in the relationship between exchange rates and inflation. This leads to empirical results that shed new light on the heterogeneity of pass-through estimates across countries and over time. Second, the chapter supplements a growing empirical literature linking the exchange rate pass-through to underlying shocks, contrasting with traditional reduced-form approaches that estimate an “average” pass-through based on the assumption of an exogenously determined exchange rate. Third, compared with earlier studies that have derived state-dependent pass-through estimates, their work investigates a greater menu of shocks, uses a larger sample of countries, and employs a state-of-the-art econometric framework that combines domestic and global shocks.<sup>11</sup> Finally, the chapter explores the role of some EMDE-specific characteristics, including monetary policy frameworks, participation in global value chains, and foreign currency invoicing.

This approach yields estimates of exchange rate pass-throughs that differ widely by the source of shocks and country characteristics. The approach produces the following results. First, domestic shocks were the main driver of exchange rate fluctuations across most countries but resulted in

> 11 Past empirical studies disentangling the impacts of different types of shocks on estimated pass-throughs include Forbes, Hjortsoe, and Nenova (2017, 2018) and Shambaugh (2008).

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