Exchange Rate Volatility, Passthrough, and Inflation Targeting

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Exchange Rate Volatility,Pass-through, and
Inflation Targeting

• Paul Storer
• Steven Globerman
• Western Washington University

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Goals of this Paper

• Document increased high-frequency volatility of
  the nominal Canada-U.S. exchange rate.
• Examine effect of volatility on border effects in
  consumer prices.
• Explore links between volatility and policy.

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Exchange Rate Volatility

• Increase in late 1990s

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Daily Change of Log(PFX)
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1975-1996
Daily Changes In Log(PFX)
1997-2005
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Border Effects and Prices

• Engel and Rogers (1996) Method

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Relative Prices Basic Unit of Empirical Analysis
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Why do price effects matter?

• Recall the micro-based arguments for price
  stability prices allocate resources
• Increasing integration of production and
  distribution in North America requires
  cross-border resource allocation.
• Does exchange rate volatility impede micro-level
  efficiency ?

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Estimating Border Effects

• Step One Generate 91 time series of relative
  price ratios for 14 cities (total (1413)/2)
• Step Two Calculate the standard deviation si,j
  for each time series over a given sample period.
• Step Three Use the 91 standard deviations in a
  cross-sectional regression with distance and
  border variables.

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Key Coefficients from the Cross-Sectional
Regression
Variability of Relative Prices Between cities i
and j
Spatial separation
Incremental border effect
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Table One Regression Analysis of Border Width
Note Standard errors are in parentheses below
the coefficient estimates.
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Border Effects and Exchange Rate Volatility
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Central Bank Reaction Function

• Taylors indirect exchange rate channel and low
  pass-through

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Modified Taylor Rule
Change rule modification
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(No Transcript)
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Ratio of SD of Changes in PFX vs. R Components of
the MCI
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Exchange Rate Volatility and Fundamentals
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Volatility of PFX Non-energy Commodities
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Volatility of Total Non-energy Commodity Prices
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Miscellaneous Facts
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Grubel-Lloyd Index of Intra-Industry Trade
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Dispersion of 8 Inflation Categories
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Conclusions

• The exchange rate might enhance an inflation
  targeting rule when pass-through is low.
• The change in exchange rate volatility deserves
  further study.
• The micro-effects of price dispersion need to be
  included in policy calculations.