What drives exchange rate pass-throughs? Evidence from a non-parametric method
Summary
Focus
The extent to which exchange rate changes affect consumer prices typically varies a lot between countries and time periods. While there is a large empirical literature on measuring exchange rate pass-through, much less is known about which specific factors drive the magnitude of exchange rate pass-through and the relative contribution of these different factors.
Contribution
We provide new evidence on the drivers of exchange rate pass-through across four decades and in close to a hundred economies. To do this, we combine conventional econometrics and the method of random forests. Random forests are particularly useful for modelling highly non-linear relationships, as well as for identifying the relative importance of the different factors that can affect the degree of pass-through.
Findings
Our analysis identifies the size of the economy and the level of inflation as the factors most strongly associated with the extent of pass-through. These are followed by the degree of product homogeneity and exchange rate volatility. When it comes to policy regimes and outcomes, we find that the degree of pass-through is lowest for small deviations of inflation from its target, when the de facto exchange rate regime is either a managed or a free float, and when fiscal policy credibility – proxied by sound fiscal accounts – is high.
Abstract
We provide new evidence on the drivers of the pass-through of exchange rate movements into consumer prices across four decades and close to a hundred countries, combining econometrics and random forests. Random forests are particularly useful for modelling highly non-linear relationships, as well as for identifying the relative importance of the different theoretical factors that can affect the degree of pass-through. We find that the size of the economy, which tends to be related to the extent of pricing-to-market, and the level of inflation emerge as the factors most strongly associated with exchange rate pass-through, followed by product homogeneity and the volatility of the exchange rate. As we show, several of these covariates display a non-linear relation with exchange rate pass-throughs. We also document important implications of macroeconomic policy regimes and outcomes, including those related to fiscal policy, for exchange rate pass-through.
JEL Codes: E30, E31, E58, F31, F41
Keywords: inflation, exchange rate pass-through, Phillips curve
