# 5.3. Impact of exchange rate shocks

Finally, the NEER shock, which is the last variable in the Cholesky ordering, effectively picks up all shocks that move the NEER and are not covered by the first five shocks. Accordingly, the response of domestic core inflation to these NEER disturbances indicates the extent of the exchange rate pass-through to core inflation, irrespective of the underlying shock to the NEER. The estimated pass-through is more pronounced in LICs than in advanced economies or other EMDEs (Figure 4). This finding is overall consistent with the findings in Ha, Stocker, and Yilmazkuday (2019) where the estimates of the pass-through ratio are on average greater in EMDEs than in advanced economies, although the country group in that paper includes few LICs. This may again reflect a weaker anchoring of inflation expectations in LICs than in the other country groups, due to weaker commitment to medium-term inflation objectives on the part of LIC central banks and greater challenges to that commitment posed by larger imported components of headline CPI.

# 5.4. Impacts of the shocks, by exchange rate regime

To shed more light on the differences between LICs and other country groups in the transmission of global and domestic shocks into domestic core inflation, IRFs were estimated separately for countries with fixed and flexible exchange rate regimes (Figure 5). For advanced economies and other EMDEs, the response of domestic core inflation to global core price shocks was larger in countries with fixed exchange rate regimes. However, the opposite was true for LICs: the response to global core inflation was found to be less pronounced for LICs with fixed exchange rate regimes. An interpretation could be that LICs with fixed exchange rates are more successful in anchoring inflation expectations than those with flexible exchange rates. This may be because weak institutions make a credible commitment to price stability difficult without a credible anchor in the form of a fixed exchange rate.

# 5.5 Contributions of the shocks to core inflation variation

Variance decompositions of core inflation were examined for the three country groups, using within-group medians (Figure 6). The key differences were found between advanced economies, on the one hand, and LICs and other EMDEs on the other. Consistent with substantially stronger anchoring of domestic inflation expectations in advanced economies, more than three-quarters of the variance of core CPI inflation rates in these economies is explained by shocks to core inflation. In LICs and other EMDEs domestic core inflation is overwhelmingly explained by shocks to global core inflation. The variance share of global core price shocks in the total variation of domestic core inflation is around 60 percent for both these income groups. The contribution of shocks to domestic core inflation, by contrast, is much smaller. The share of domestic core inflation explained by global food and energy shocks is moderately larger for LICs than for advanced economies and other EMDEs. In LICs, global food and energy price shocks account for 12 percent of core inflation variation—half more than in advanced economies and one-fifth more than in nonLIC EMDEs. In line with the results from the IRFs, this result may suggest that central banks in LICs have not succeeded in anchoring inflation expectations in the face of shocks to inflation rates, and that much of LIC inflation seems to have been driven by spillovers from advanced economies and other EMDEs. This is discussed in more detail in the next section.

16