11.3 Exchange Rate Pass-through and Monetary Policy
6 min read•july 30, 2024
Exchange rate pass-through is crucial in monetary policy. It measures how exchange rate changes affect domestic prices of imports. The degree of pass-through impacts how well central banks can control inflation and influence the economy through policy decisions.
Understanding pass-through helps policymakers navigate trade-offs. High pass-through means exchange rate changes strongly affect inflation, complicating price stability goals. Low pass-through gives central banks more flexibility to focus on domestic objectives without worrying as much about currency fluctuations.
Exchange Rate Pass-Through
Definition and Relevance
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- Exchange rate pass-through measures how changes in the exchange rate impact domestic prices of imported goods and services
- The degree of exchange rate pass-through significantly affects the effectiveness of monetary policy in achieving price stability and influencing domestic economic conditions
- Higher exchange rate pass-through means changes in the exchange rate have a more substantial impact on domestic inflation, while lower pass-through indicates a weaker link between exchange rate fluctuations and domestic prices
- The extent of exchange rate pass-through varies across countries (developed vs. emerging economies), sectors (tradable vs. non-tradable goods), and time periods (short-run vs. long-run)
- Understanding the nature and magnitude of exchange rate pass-through is essential for central banks to formulate appropriate monetary policy responses to exchange rate movements
Transmission Mechanism and Implications
- The degree of exchange rate pass-through has significant implications for the transmission of monetary policy shocks to the domestic economy
- In the presence of high exchange rate pass-through, changes in the exchange rate resulting from monetary policy actions have a more pronounced effect on domestic prices and inflation
- An appreciation of the domestic currency following a contractionary monetary policy shock leads to lower import prices and reduced inflationary pressures (tighter monetary conditions)
- A depreciation of the currency due to an expansionary monetary policy shock results in higher import prices and increased inflation (looser monetary conditions)
- The impact of exchange rate pass-through on domestic output depends on the net effect of changes in the exchange rate on exports, imports, and domestic demand
- An appreciation of the currency makes exports less competitive and reduces foreign demand, while making imports cheaper and potentially boosting domestic consumption (expenditure switching effect)
- The overall effect on output depends on the relative strength of these channels and the specific characteristics of the economy (, import dependence)
- High exchange rate pass-through complicates the task of monetary policy in achieving price stability, as exchange rate fluctuations have a more direct and immediate impact on domestic prices
- Central banks need to consider the degree of exchange rate pass-through when assessing the appropriate monetary policy stance and the potential trade-offs between price stability and output stabilization
Factors Influencing Pass-Through
Market Structure and Pricing Behavior
- The market structure of the importing country, such as the level of competition and the presence of monopolistic or oligopolistic firms, affects the degree of exchange rate pass-through
- Firms with greater market power have more flexibility in absorbing exchange rate changes and may choose to maintain stable prices to preserve market share, resulting in lower pass-through (pricing to market)
- The pricing behavior of firms, such as the use of local currency pricing (LCP) or producer currency pricing (PCP), influences the extent of exchange rate pass-through
- LCP involves setting prices in the currency of the importing country, which insulates domestic prices from exchange rate fluctuations and leads to lower pass-through (invoicing in local currency)
- PCP involves setting prices in the currency of the exporting country, which results in higher pass-through as exchange rate changes are directly transmitted to import prices (invoicing in producer currency)
- The share of imported inputs in domestic production and the degree of substitutability between domestic and foreign goods affect the magnitude of exchange rate pass-through (import content of production)
- The presence of long-term contracts and the frequency of price adjustments by firms influence the speed and extent of pass-through ()
Macroeconomic and Structural Factors
- Macroeconomic factors, such as inflation expectations, economic growth, and the credibility of monetary policy, shape the degree of exchange rate pass-through over time
- Countries with a history of high and volatile inflation tend to have higher exchange rate pass-through, as firms and consumers are more sensitive to exchange rate changes ()
- Economies with a more diversified production structure and a larger non-tradable sector may experience lower exchange rate pass-through, as the impact of exchange rate fluctuations on overall prices is more limited ()
- The level of economic development and the depth of financial markets can influence the degree of exchange rate pass-through, with more developed economies generally exhibiting lower pass-through ()
- Structural reforms that enhance competition, reduce trade barriers, and promote price flexibility can affect the degree of exchange rate pass-through over time ()
Implications for Monetary Policy
Challenges in Achieving Price Stability
- The presence of high exchange rate pass-through complicates the task of monetary policy in achieving price stability, as exchange rate fluctuations have a more direct and immediate impact on domestic prices
- Central banks may face a trade-off between stabilizing the exchange rate and achieving domestic price stability
- Attempts to stabilize the exchange rate through interventions or adjustments in monetary policy may conflict with the goal of maintaining low and stable inflation ()
- Focusing solely on domestic price stability may lead to greater and potential economic disruptions ()
- Central banks need to carefully assess the costs and benefits of different policy responses to exchange rate movements, considering the specific characteristics of their economies and the degree of exchange rate pass-through
Policy Considerations and Trade-offs
- The effectiveness of monetary policy in managing exchange rate volatility may be limited by the presence of capital flows, speculative activities, and external shocks (global financial conditions)
- Central banks may need to employ a range of tools and policy instruments, such as foreign exchange interventions, macroprudential measures, and communication strategies, to mitigate the impact of exchange rate volatility on the economy ()
- The choice between exchange rate stability and monetary policy autonomy depends on the exchange rate regime and the degree of capital mobility ()
- In a flexible exchange rate regime, monetary policy can focus on domestic objectives, while the exchange rate is allowed to adjust in response to economic fundamentals and market forces (floating exchange rates)
- In a regime, monetary policy is subordinated to the goal of maintaining the exchange rate peg, limiting the ability to respond to domestic economic conditions ()
Managing Exchange Rate Volatility
Policy Responses and Interventions
- Exchange rate volatility poses several challenges for central banks in conducting monetary policy and maintaining macroeconomic stability
- Excessive exchange rate fluctuations create uncertainty and disrupt trade flows (), investment decisions (), and financial stability ()
- Central banks may intervene in foreign exchange markets to smooth out excessive volatility and prevent disorderly market conditions (foreign exchange interventions)
- Sterilized interventions involve buying or selling foreign currency while simultaneously conducting offsetting to maintain the domestic money supply ()
- Non-sterilized interventions involve changing the domestic money supply in response to foreign exchange transactions, which can affect domestic monetary conditions ()
- Macroprudential measures, such as capital controls and foreign currency reserve requirements, can be used to manage capital flows and mitigate the impact of exchange rate volatility on the financial system ()
International Policy Coordination
- International and cooperation among central banks are important in addressing global factors that contribute to exchange rate volatility and its spillover effects across countries
- Central banks may engage in coordinated interventions or joint policy actions to address common challenges and promote global financial stability (policy coordination)
- International forums, such as the G20 and the International Monetary Fund (IMF), provide platforms for policy dialogue, information sharing, and multilateral surveillance of exchange rate policies ()
- Adherence to international norms and best practices, such as avoiding competitive devaluations and promoting transparency in exchange rate policies, can help mitigate exchange rate volatility and its adverse effects ()
- Effective communication and forward guidance by central banks can help anchor expectations and reduce uncertainty surrounding exchange rate movements and monetary policy intentions ()
Key Terms to Review (36)
Ben Bernanke: Ben Bernanke is an American economist who served as the Chairman of the Federal Reserve from 2006 to 2014, overseeing critical monetary policy decisions during the Great Recession. His leadership and policies, particularly in times of economic crisis, have influenced discussions on monetary policy frameworks, central bank independence, and financial stability.
Capital flight: Capital flight refers to the rapid exit of financial assets or capital from a country, typically triggered by economic instability, political unrest, or unfavorable financial conditions. This phenomenon can have profound effects on a nation's economy, influencing exchange rates, monetary policy, and the overall financial landscape, especially in emerging markets and during periods of crisis.
Central bank communication: Central bank communication refers to the strategies and methods used by central banks to convey information about their monetary policy intentions, economic outlook, and other relevant financial information to the public and markets. Effective communication helps shape expectations, influences financial conditions, and enhances transparency, which can be crucial for achieving economic stability and maintaining credibility.
Central bank intervention: Central bank intervention refers to the actions taken by a country's central bank to influence the value of its currency in the foreign exchange market. This is often done to stabilize the currency, control inflation, or achieve other economic objectives such as supporting exports. The effectiveness of such interventions can be impacted by factors like market perceptions, interest rates, and economic conditions, which also relate closely to exchange rate pass-through and monetary policy decisions.
Currency appreciation: Currency appreciation refers to an increase in the value of one currency relative to another in the foreign exchange market. This phenomenon can occur due to various factors, including changes in interest rates, inflation rates, and economic stability, which influence investor confidence and capital flows. As a currency appreciates, it can lead to cheaper imports and more expensive exports, impacting trade balances and monetary policy decisions.
Currency depreciation: Currency depreciation refers to the decrease in the value of a country's currency relative to other currencies, making foreign goods and services more expensive while domestic goods become cheaper for foreign buyers. This phenomenon can occur due to various factors, including economic conditions, interest rates, and government policies, influencing international trade dynamics and monetary policy responses.
Economic Structure and Trade Openness: Economic structure refers to the composition and organization of different sectors within an economy, including agriculture, manufacturing, and services. Trade openness measures how freely a country engages in international trade, including the reduction of tariffs and other barriers. Understanding the interaction between economic structure and trade openness is vital as it influences exchange rate pass-through, inflation dynamics, and monetary policy effectiveness.
Exchange rate targeting: Exchange rate targeting is a monetary policy strategy where a country's central bank aims to maintain the value of its currency at a fixed exchange rate to another currency or a basket of currencies. This approach is often used to stabilize a nation’s economy by controlling inflation and providing certainty for trade and investment, which connects to historical shifts in monetary systems and the dynamics of monetary policy.
Exchange rate volatility: Exchange rate volatility refers to the degree of fluctuation in the value of one currency relative to another over a specific period. This variability can have significant implications for international trade, investment, and economic stability, affecting how businesses and governments plan their financial strategies and policies.
Financial market development: Financial market development refers to the process of improving the efficiency, accessibility, and stability of financial markets, enabling better allocation of resources and investment opportunities. This development involves creating a robust regulatory framework, enhancing financial instruments, and promoting transparency, which together facilitate smoother transactions and investor confidence. As financial markets develop, they play a crucial role in the transmission of monetary policy and in influencing exchange rates.
Financial market volatility: Financial market volatility refers to the degree of variation in trading prices over time in financial markets, often characterized by rapid price fluctuations and unpredictability. This instability can significantly impact investment decisions and economic outcomes, as it reflects the uncertainty surrounding market conditions, investor sentiment, and external shocks such as changes in monetary policy or exchange rates.
Financial stability tools: Financial stability tools are measures and instruments implemented by monetary authorities to promote a stable financial system and mitigate risks that could lead to financial instability. These tools are crucial for ensuring the resilience of the banking sector, managing inflation, and addressing the impact of exchange rate fluctuations on the economy. They include various regulatory, supervisory, and policy measures designed to enhance the overall functioning of financial markets.
Fixed exchange rate: A fixed exchange rate is a monetary system where a country's currency value is tied or pegged to another major currency or a basket of currencies, maintaining a stable exchange rate over time. This system is crucial for promoting trade stability, as it reduces the risk of exchange rate fluctuations that can affect international transactions.
Floating Exchange Rate: A floating exchange rate is a currency system where the value of a currency is determined by market forces, primarily supply and demand, rather than being fixed or pegged to another currency. This dynamic nature allows for adjustments in response to economic conditions, trade balances, and speculation, impacting monetary policy decisions and international trade relationships.
Foreign direct investment: Foreign direct investment (FDI) refers to an investment made by a company or individual in one country in business interests in another country, typically through the establishment of business operations or the acquisition of assets. This form of investment plays a crucial role in shaping international economic relationships, influencing balance of payments, capital flows, and monetary policy decisions across borders.
Inflation history and expectations: Inflation history and expectations refer to the patterns and predictions surrounding the rate at which prices for goods and services rise over time, impacting the purchasing power of money. These concepts are interconnected, as historical inflation trends inform future expectations, influencing consumer behavior and monetary policy decisions. Understanding both aspects is crucial for central banks when formulating strategies to manage inflation and stabilize the economy.
Inflation Targeting: Inflation targeting is a monetary policy strategy where a central bank sets a specific inflation rate as its goal and uses various tools to achieve that target. This approach helps anchor expectations about future inflation, guiding economic decision-making by households and businesses while also promoting transparency and accountability in monetary policy.
Interest rate adjustments: Interest rate adjustments refer to the changes made by central banks to the benchmark interest rates that influence borrowing and lending across the economy. These adjustments are essential tools for managing economic growth, inflation, and overall monetary policy, impacting various aspects such as consumer spending, investment decisions, and international capital flows.
Interest Rate Parity: Interest rate parity is a fundamental principle in international finance that states the relationship between interest rates and exchange rates should be such that an investor cannot achieve arbitrage profits by capitalizing on differences in interest rates between two countries. This concept helps to explain how capital flows and currency exchange rates are influenced by interest rates, which is crucial for understanding the dynamics of currency markets and international trade.
International Standards and Norms: International standards and norms are agreed-upon principles and guidelines that govern behavior, practices, and policies across nations, aiming to ensure consistency and quality in various fields. These standards help facilitate international trade, enhance cooperation among countries, and promote stability in the global economy by establishing a common framework for economic interactions.
Investment uncertainty: Investment uncertainty refers to the unpredictability surrounding the potential returns and risks associated with investing in financial assets or projects. This uncertainty can arise from various factors, such as market volatility, economic conditions, and changes in government policies, which can affect investors' confidence and willingness to commit capital.
Milton Friedman: Milton Friedman was a renowned American economist and a leading advocate of monetarism, emphasizing the role of government in regulating the economy through monetary policy. His work challenged existing economic paradigms, promoting the idea that changes in the money supply have significant effects on inflation and economic stability.
Monetary impact: Monetary impact refers to the effects that monetary policy decisions, such as interest rate changes or adjustments in money supply, have on economic variables like inflation, exchange rates, and overall economic activity. This impact is crucial in understanding how policy measures influence both domestic and international economic conditions, especially in relation to exchange rate fluctuations and their subsequent effects on prices and output.
Multilateral frameworks: Multilateral frameworks are structured systems of cooperation among multiple countries that aim to address global issues through collective action. These frameworks facilitate collaboration on economic policies, trade regulations, and diplomatic relations, helping to create a more stable and predictable global environment. They are crucial in promoting international cooperation in areas such as monetary policy and economic stability, often influencing exchange rate dynamics.
Open market operations: Open market operations are the buying and selling of government securities in the open market by a central bank to regulate the money supply and influence interest rates. This tool is crucial for implementing monetary policy, as it directly affects liquidity in the banking system and can signal the central bank's stance on economic conditions.
Output Gap: The output gap is the difference between the actual output of an economy and its potential output at full capacity. This concept helps economists understand whether an economy is underperforming, indicated by a negative output gap, or overheating, represented by a positive output gap, and it connects deeply with various economic policies and frameworks.
Pegged exchange rates: Pegged exchange rates are a type of fixed exchange rate where a country's currency value is tied or pegged to another major currency, often the US dollar or gold. This system helps stabilize a nation's currency by reducing fluctuations in exchange rates, which can have significant implications for trade and economic policy.
Policy coordination: Policy coordination refers to the alignment and collaboration between different governments or institutions to achieve common economic goals, particularly in monetary and fiscal policies. This approach helps mitigate potential conflicts and enhances the effectiveness of economic policies across countries, especially in a globally interconnected economy.
Policy toolkit: A policy toolkit refers to a collection of instruments, strategies, and techniques that policymakers use to influence economic outcomes and achieve specific goals. This toolkit is essential in the context of monetary policy, where central banks deploy various tools to manage inflation, employment, and economic stability, particularly in response to changes in exchange rates and other economic variables.
Price Stickiness: Price stickiness refers to the phenomenon where prices of goods and services are resistant to change, even in response to shifts in demand or supply. This behavior can lead to slow adjustments in the economy when there are changes in monetary policy or external factors, such as exchange rates. The persistence of certain prices can affect inflation rates and the overall effectiveness of monetary policy, as central banks may struggle to influence economic activity when prices do not adjust quickly.
Purchasing Power Parity: Purchasing Power Parity (PPP) is an economic theory that states that in the long run, exchange rates between currencies should adjust so that identical goods cost the same in different countries. This principle is crucial for understanding how currency values relate to the cost of living and inflation across nations, highlighting the importance of relative prices in shaping exchange rate movements.
Sterilization: Sterilization refers to the process by which central banks take measures to offset the effects of foreign capital inflows or outflows on domestic monetary policy. By conducting sterilization operations, central banks aim to maintain control over domestic money supply and interest rates, preventing fluctuations caused by changes in foreign currency reserves. This practice is particularly relevant in managing the impacts of exchange rate pass-through on inflation and economic stability.
Structural Policies and Reforms: Structural policies and reforms refer to deliberate actions taken by governments or institutions aimed at changing the underlying economic structure of a country to enhance economic performance, improve efficiency, and stimulate growth. These policies can influence various sectors of the economy, impacting areas like labor markets, industry regulations, and financial systems, thereby affecting how well a country responds to external shocks, including changes in exchange rates.
Trade disruptions: Trade disruptions refer to interruptions in the normal flow of goods and services between countries, often caused by factors such as natural disasters, geopolitical tensions, or economic policies. These disruptions can significantly impact economies by altering supply chains, affecting currency values, and influencing monetary policy decisions.
Trade openness: Trade openness refers to the extent to which a country allows goods and services to flow freely across its borders, facilitating international trade. This concept is crucial because it reflects a country's integration into the global economy and can impact its economic growth, exchange rate stability, and monetary policy effectiveness.
Trilemma of International Finance: The trilemma of international finance, also known as the impossible trinity, is a concept in economics that states it is impossible for a country to maintain a fixed foreign exchange rate, free capital movement, and an independent monetary policy simultaneously. This means that countries must choose two out of these three goals, leading to trade-offs in their economic policies. The implications of this trilemma are significant for understanding how exchange rates respond to monetary policy changes and how central banks navigate these trade-offs in practice.