Monetary Policy and Exchange Rate Passthrough: Theory and Evidence

1
Monetary Policy and Exchange Rate Pass-through
Theory and Evidence

• Michael B. Devereux and James Yetman

2
Main Features

• The paper develop a model of exchange rate
  pass-through based on the frequency of price
  changes by importing firms
• The price change frequency is influenced by the
  monetary policy rule.
• looser monetary policy rule lead to high mean
  inflation and high volatility of the exchange
  rate.
• Prediction there should be positive relationship
  between pass through and mean inflation and
  between pass through and exchange rate
  volatility.

3
The Importing Firm

• If the firm can freely adjust the price, then

4
A menu cost F

• As in Calvo (1983) there is a probability
• that firms change prices at any period. The
  optimal price for the newly price setting firm
  is

(1)
5
Price index for imported goods
(2)
6
Determination of the exchange rate

• Equations (1) and (2) determine the degree of
  pass-through from exchange rates to prices.
• The monetary rule
• The home consumer Euler conditions

(3)
(4)
(5)
7
Inflation and real exchange rate determination

• The combination of the interest rule , (5), the
  Euler equations, (3) and (4), and foreign firm
  pricing equations, (1) and (2), determine
  inflation and real exchange rate determination.

8
Inflation equation for imported goods prices

• Combining (1) and (2) yields the imported price
  inflation
• (6)

9
Log Linearization

• Approximation of the Euler conditions yields
• Interest Parity
• Interest rule---
• Combining the two
• relationships yields
• A relationship in real exchange rate and
  inflation--- (7)

10
Equations (6) and (7) give a simple dynamic
system in domestic inflation and the real
exchange rate

• With autoregressive stochastic processes these
  equations are solved

11
Intuition

• If the monetary authority has a target for
  nominal interest rate which is smaller than the
  foreign interest rate,
• , then the steady state inflation is positive,
  and relatively high real exchange rate.

12

• The higher is the coefficient on inflation in the
  monetary rule, the smaller are both mean
  inflation and steady state depreciation in the
  real exchange rate. Hence for a given parameter
• tighter monetary policy ( high )
  implies a lower mean inflation.

13
Exchange Rate Pass-Through

• From equation (6) DY write the equations for the
  domestic price level, and nominal exchange rate

14
Real foreign interest rate shocks

• Focusing on the effect of real foreign interest
  shocks, or equivalently, domestic monetary
  shocks, DY demonstrate that the exchange rate
  responds by more than the domestic price levels,
  since such shocks cause both immediate real
  depreciation as well as domestic inflation.
• For a given value of
• Monetary policy has no effect on pass through.

15
Endogenous Price Rigidity

• With menu costs, the higher is inflation, the
  more costly it is for a firm to set its price in
  terms of domestic currency, and have the profits
  eroded by exchange rate depreciation. DY
  postulate the following choice problem for

16
(No Transcript)
17
Depends on the monetary rule. The main finding is
that the exchange rate pass through also depends
on the monetary rule!
18
Critique

• Output is treated as an exogenous variable.
• Thus, the output gap does not play a role in the
  pass through from the exchange rate to domestic
  prices.
• An extension will produce a new Keynesian
  aggregate supply relationship, as in Loungani,
  Razin and Yuen

19
Open-Economy New-Keynesian Phillips Curve
20
(No Transcript)
21
(No Transcript)
22
(No Transcript)
23
(No Transcript)
24
(No Transcript)
25
Firms Optimization
Nominal
Real
26
Flexible prices
Set price one period in advance
27
ONE-PERIOD NOMINAL RIDIGITY
28
(No Transcript)
29
Steady state
30
The Phillips Curve
31
where
Elasticity of marginal product of labor wrt output
Elasticity of wage demands, wrt to output,
holding marginal utility of income constant
32
Log-linearization of real mc
Partial-equilibrium relationship?
33
(No Transcript)
34
(No Transcript)
35
Closing the capital account
Closing the trade account
36
Sacrifice Ratios in Closed vs. Open Economies An
Empirical Test

• Prakash Loungani, Assaf Razin, and Chi-Wa Yuen

37
Background
Lucas (1973) proposed a model in which the effect
arises because agents in the economy are unable
to distinguish perfectly between aggregate and
idiosyncratic shocks he tested this model at the
aggregate level by showing that the Phillips
curve is steeper in countries with more variable
aggregate demand. Ball, Mankiw and Romer (1988)
showed that sticky price Keynesian models predict
that the Phillips curve should be steeper in
countries with higher average rates of inflation
and that this prediction too receives empirical
support
38
DATA
The data used in the regressions reported in this
paper are taken from Ball (1993, 1994) and Quinn
(1997). Sacrifice ratios and their
determinants Our regressions focus on explaining
the determinants of sacrifice ratios as measured
by Ball. He starts out by identifying
disinflations, episodes in which the trend
inflation rate fell substantially. Ball
identifies 65 disinflation episodes in 19
OECD countries over the period 1960 to 1987. For
each of these episodes he calculates the
associated sacrifice ratio. The denominator of
the sacrifice ratio is the change in trend
inflation over an episode. The numerator is the
sum of output losses, the deviations between
output and its trend (full employment) level.
39
Sacrifice ratios and their determinants Our
regressions focus on explaining the determinants
of sacrifice ratios as measured by Ball. He
starts out by identifying disinflations, episodes
in which the trend inflation rate fell
substantially. Ball identifies 65 disinflation
episodes in 19 OECD countries over the period
1960 to 1987. For each of these episodes he
calculates the associated sacrifice ratio. The
denominator of the sacrifice ratio is the change
in trend inflation over an episode. The numerator
is the sum of output losses, the deviations
between output and its trend (full employment)
level.
40
For each disinflation episode identified by Ball,
we use as an independent variable the current
account and capital account restrictions that
were in place the year before the start of the
episode. This at least makes the restrictions
pre-determined with respect to the sacrifice
ratios, though of course not necessarily
exogenous.
41
Capital Flow Restrictions
Quinn (1997) takes the basic IMF qualitative
descriptions on the presence of restrictions and
translates them into a quantitative measure of
restrictions using certain coding rules. This
translation provides a measure of the intensity
of restrictions on current account transactions
on a (0,8) scale and restrictions on capital
account transactions on a (0,4) scale in both
cases, a higher number indicates fewer
restrictions. We use the Quinn measures, labeled
CURRENT and CAPITAL, respectively, as our
measures of restrictions.
42
Sacrifice ratios and Openness Restrictions
43
Conclusion
In our earlier work we showed that restrictions
of capital account transactions were significant
determinants of the slope of the Phillips curve,
as measured in the studies of Lucas (1973),
Ball-Mankiw-Romer (1998), and others. The
findings of this note lend support to this line
of work, in particular to the open economy new
Keynesian Phillips curve developed in Razin and
Yuen (2001). We find that sacrifice ratios
measured from disinflation episodes depend on the
degree on restrictions on the current account and
capital account. Of course, to be more convincing
this finding will have to survive a battery of
robustness checks, such as sub-sample stability,
inclusion of many other possible determinants
(such as central bank independence) in the
regressions, and using instruments to allow for
the possible endogeneity of the measures of
openness.