Exchange rate pass-through:a VECM estimation analysis in the G7 and the asian tigers.

Abstract

The present thesis explores the magnitude of the exchange rate pass-through to domestic prices and the differences across two economic groups, an emerging market, the Asian Tigers, and a fully industrialised one, G7, using Vector Error Correction Models. The study is important for monetary policy determination because of its implications on the trade balance and for a country’s choice of an exchange rate regime. The chosen modelling framework allows one to trace out the dynamic responses of variables to random exogenous disturbances over time. Information on the size and the speed of the pass-through is derived from impulse response functions based upon Cholesky decomposition. The pairwise Granger causality tests between the variables of each country model were taken into account to judge about the most appropriate VAR ordering of the system in each case. The results are in line with previous studies where exchange rate pass-through is incomplete both in the short-run and the long-run in most cases. The size and the speed of pass-through declines along the distribution chain but not in all countries considered. Thus, the analysis partly overturns the conventional wisdom that exchange rate pass-through is always considerably higher in emerging than in developed economies. Besides, the results are not quite persistent. In addition, weak correlation between trade openness and the degree of exchange rate pass-through as well as between this and inflation has been detected. As a matter of fact, we can say that in average the more-self-sufficient, with-lower-inflation developed economies exhibit lower levels of pass-through with the exception of Germany and France. Finally, exchange rate shocks do not have high explanatory power on movements in domestic prices in every country model. In average, however, in the-most-international trade-dependent, with-higher-inflation emerging economies domestic prices fluctuations are more due to exchange rate innovations than those of the G7 block.