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Pass-through, exchange rates, and monetary policy.

Article Excerpt
THIS CONFERENCE IS devoted to examining the forces that lead to incomplete pass-through of exchange rates into domestic prices. My comments are divided into two separate parts. First, I will examine whether, and to what extent, monetary policy should be concerned with pass-through. Second, I will ask whether monetary policy should pay attention to exchange rates beyond concern about their effect on local nominal prices.

1. PASS-THROUGH

There is a body of evidence that pass-through has declined in recent years (most notably, see Marazzi et al. 2005). Does this have meaningful implications for inflation and monetary policy?

In the long run, inflation in each country that has its own currency will be determined by monetary growth relative to output growth. Consider the classical world in which the quantity equation (holding velocity constant) holds. It tells us that % [DELTA]p = % [DELTA]m - %[DELTA]y, where p is the log of prices, m is the log of the money supply, and y is the log of output. Although it is not popular or useful to characterize monetary policy as a rule determining growth in the money supply, money as an abstract construct is still useful in understanding inflation. That is, it is difficult or impossible to measure the money supply that is relevant for determining nominal prices. But we can nonetheless think of an ideal measure of money that serves as the nominal anchor. If a central bank allows the amount of money in circulation to rise, prices will rise.

Suppose in addition that purchasing power parity holds, so that %[DELTA]s = %[DELTA]p - %[DELTA][p.sup.*], where s is the home currency price of foreign currency (the dollar price of euros), and %[DELTA][p.sup.*] is foreign inflation (consumer price inflation in Europe, expressed in euros.)

What does pass-through mean in this world? If the home money supply growth increases by 1%, then home inflation will increase by 1% and the home currency will depreciate by 1%. That is, p and s rise equally. Apparently, "aggregate" pass-through is one for one in this case. A 1% depreciation is associated with 1% home inflation. On the other hand, if foreign money growth declines by 1% (holding home money growth constant), foreign inflation will fall 1% and the home currency will depreciate 1%, but home inflation will not change. That is, s will rise, but p will be unaffected.

Apparently, now, aggregate pass-through is zero.

This simple example illustrates two points. The first is that a country with its own currency ultimately controls its own inflation through monetary policy. The second point is that "pass-through" of exchange rates to aggregate prices is not a very well-defined concept. If pass-through is defined as the regression coefficient of inflation on the exchange rate, the degree of pass-through depends on what causes the exchange rate to change. This has been explored more fully in the context of sticky-price open-economy dynamic stochastic general equilibrium (DSGE) models by Bouakez and Rebei (2008) and Dong (2007). Indeed, Bouakez and Rebei find that the main reason for declining pass-through in Canada has been the adoption of the inflation-targeting regime.

The relevance of microeconomic studies of pass-through for the inflation question is unclear. These studies take the exchange rate change as exogenous for the firm, and ask how the firm's export price is affected. The typical model from the international trade literature has no explicit role for nominal variables. All prices are real. The question addressed is how changes in the real exchange rate influence the relative import price. As Ball (2006) has emphasized, the findings of these studies do not necessarily have any implication for inflation. If the relative price of imports to other goods is declining, that also means that the relative price of other goods is increasing. How can we draw an inference about inflation from this?

Even if these studies of pass-through do not matter for long-run inflation, there is a case that pass-through matters for the short-run dynamics of inflation. Some prices adjust more quickly than others. An increase in the price of oil, for example, might temporarily increase inflation. Why? Imagine a world where the monetary policymaker will succeed in keeping overall inflation at zero in the long run,...

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