Exchange-rate pass-through

Policy makers define exchange-rate regimes in agreement with monetary policy. As Vernengo and Rochon (2000, p. 77) point out, "preferences over a specific exchange rate regime can be linked to macroeconomic policy, in particular to whether econo- mists prefer full-employment policies or whether they defend policies aimed at guar- anteeing price stability". As several countries are adopting flexible exchange rates to prevent chronic deficits in their balance of payment (many countries were forced by speculative attacks on their national currencies to abandon fixed exchange-rate regimes), understanding the pass-through effect - the effect of exchange-rate fluctuations on the rate of inflation - became crucial as well as controversial. Many central bankers, adopt- ing mainstream recipes, are targeting inflation in order to avoid the pass-through effect, considering that exchange-rate devaluations have had substantial impacts on domestic prices. In many cases, policy makers have focused primarily on price stability, leaving aside full-employment policies.

Mainstream models rely on assumptions that market imperfections lessen the exchange rate pass-through effect. In general, these theoretical models assume that when an exog- enous change in the exchange rate occurs, domestic firms will only partially pass its costs to final prices, so that either the prices are sticky in domestic currency in the short run or firms are engaged in price discrimination. Krugman (1987) refers to the second case as "pricing to market", as firms do not change domestic prices automatically, but only proportionally to the firm's elasticity of demand.

Post-Keynesian price theory emphasizes that mainstream models of exchange-rate pass-through are inappropriate. According to Arestis and Milberg (1993-94), particular theories of the firm define the differences between post-Keynesian and neoclassical theo- ries of the exchange-rate pass-through. The post-Keynesian firm is an oligopolist with a specific internal structure and set of investment requirements, based on its long-run objective of survival and growth. This firm is fundamentally different from the profit- maximizing behaviour of the neoclassical firm, which is characterized by short-run goals. Post-Keynesian theories of pricing in manufacturing industries are based on the full- cost principle, in which a limited exchange-rate pass-through is a result of market imper- fections. In Kalecki's (1971) framework, a rise in costs for domestic or foreign firms due to a new level of the exchange rate is not fully transmitted to prices because of the degree of monopoly. In Eichner's (1976) model, a change in the exchange rate also affects the cost of raising funds internally for future investments. As a result, the firm's investment plans are altered, its markup is reduced, and the exchange rate is passed through only to a limited degree.

In other words, whereas neoclassical models imply that partial exchange-rate pass- through reflects market imperfections, the post-Keynesian approach implies that partial exchange-rate pass-through should be the norm, and there is no reason why a full or one-to-one exchange-rate pass-through should be observed in the real world. In neoclas- sical models, one possible explanation for recent lower exchange-rate pass-through levels would be that markets are now less integrated than before.

Taylor (2000) suggests an alternative explanation within the neoclassical approach for the decline of exchange-rate pass-through in a lower inflationary environment. For him, lower exchange-rate pass-through results mainly because the pricing power of firms declines as well; that is, globalization has intensified the degree of competition of domestic firms. Therefore, under this hypothesis it might be possible, especially for emerging market countries, to experience a transitions period, from high and unstable inflation environments to low and stable ones, during which the full benefits of a floating exchange-rate regime might not be observed. However, once inflation rates stabilize at a low level, the exchange-rate pass-through weakens and movements of the exchange rate put less pressure on inflation, allowing the economy to fully benefit from exchange-rate flexibility.

Baqueiro et al. (2003) also point out that the level of the exchange-rate pass-through depends on the inflation environment. For a group of small open economies that in recent years have experienced disinflation processes, the level of the exchange-rate pass- through weakened as the rate of inflation fell. This result suggests that when a low and stable inflation environment is achieved, agents' expectations are likely to be in line with the authorities' inflation target and thus to be less influenced by short-term exchange- rate variations. Under such circumstances it is difficult to understand why the "fear of floating" phenomenon should persist. Credibility in monetary policy as well as competi- tive markets should lead to free floating and reduced exchange-rate pass-through effects. However, "fear of floating" is pervasive (Calvo and Reinhart, 2002).

In other words, according to conventional wisdom, partial exchange-rate pass-through results from imperfections and sluggish price adjustment, which seems contradictory in a more integrated world, or in a more competitive environment associated with globali- zation, leading to the logical result that central banks should let the exchange rate float, which is not a feature of the real world.

From a theoretical point of view, it would seem that post-Keynesian models would provide a sounder basis for analysis. The hypothesis that globalization has reduced the degree of monopoly of domestic firms is perfectly compatible with the full-cost princi- ple. However, post-Keynesians do not argue that once lower exchange-rate pass-through effects are established, price stability would depend on the credibility of the central bank. Hence, the "fear of floating" phenomenon is not associated with a lack of credibility, and is not a puzzling result. In a post-Keynesian framework, "fear of floating" would result from the central bankers' "fear of inflation". In a contested terrain view of central banking - one in which monetary policy affects income distribution - the central bank attaches considerably more importance to inflation than to unemployment in policy deci- sions. In that case, even when exchange-rate pass-through effects fall considerably, central banks attach greater importance to any inflationary shock, no matter how small.

See also:

Central bank credibility; Credibility and reputation; Fear of floating; Inflation targeting; Interest rate pass-through; Monetary policy and income distribution; Monetary policy in a small open economy.