Exchange Rate Pass-Through to Consumer Prices: The Increasing Role of Energy Prices

Abstract

A number of researchers have found that the rate of exchange rate pass-through (ERPT) to domestic prices has declined substantially over the last few decades. We revisit this claim of a shrinking exchange rate effect on the Consumer Price Index (CPI) in a vector autoregressive (VAR) model for US macroeconomic data under the current floating exchange rate regime. Our VAR approach nests the conventional single equation method and reveals statistically significant evidence of ERPT to the CPI only during later observations, sharply contrasting with previous findings. After confirming structural breaks in ERPT via statistical tests by Hansen (Journal of Economic Perspectives, 15(4), 117–128, 2001) and Qu and Perron (Econometrica, 75(2), 459–502, 2007), we seek the source with disaggregated level CPIs, and pin down a key role of energy prices. US energy imports increased from the 1990s until the recent recession. This market changes magnify the effects of the exchange rate shocks on domestic energy prices, resulting in greater responses of the total CPI via the energy price channel.

Appendix

Table 5 ERPT Estimates: IRF Approach $\mathbf {x}_{t}={\sum }_{j=1}^{q}\mathbf {B}_{j}\mathbf {x}_{t-j}+\mathbf {Cu} _{t},~\mathbf {x}_{t}=[{\Delta } s_{t}~~{\Delta } y_{t}~~{\Delta } p_{t}]^{\prime }$ $\phi (j)=E\left ({\Delta } p_{t+j}|u_{\Delta s,t}=1,{\Omega }_{t-1}\right ) -E\left ({\Delta } p_{t+j}|{\Omega }_{t-1}\right ) ,$ $\eta (j)={\sum }_{s=0}^{j} \phi (s)$

Table 6 ERPT Estimates: VAR Coefficients Approach $\mathbf {x}_{t}={\sum }_{j=1}^{q}\mathbf {B}_{j}\mathbf {x}_{t-j}+\mathbf {Cu} _{t},~\mathbf {x}_{t}=[{\Delta } s_{t}~~{\Delta } y_{t}~~{\Delta } p_{t}]^{\prime }$ ${\Delta } p_{t}={\sum }_{j=1}^{q}\beta _{p,j}{\Delta } p_{t-j}+{\sum }_{j=0}^{q} \beta _{s,j}{\Delta } s_{t-j}+{\sum }_{j=0}^{q}\beta _{y,j}{\Delta } y_{t-j} +\varepsilon _{t}$ $ERPT=\frac {{\sum }_{j=0}^{q}\beta _{s,j}}{1-{\sum }_{j=1}^{q}\beta _{p,j}}$