Assessing exchange rate pass-through: A new empirical approach

Recent work by Devereux, Engel, and Storgaard (2004, JIE, pp. 286), suggests that one of the key channels through which monetary policy may work is by changing the degree of pass-through. Inspired by this observation, we develop a unified estimation framework within a fully specified open macroeconomic model where both pass-through and exchange rates are endogenously determined so as to empirically assess the importance of exchange rate pass-through. We are able to identify and estimate economically meaningful long-run equilibrium conditions. Further, our empirical framework allows policymakers to precisely assess the extent of pass-through and identify the origin of pass-through in terms of economically interpretable impulses. We center the policy discussion on exchange rate management opted for a more stable domestic price level. Our empirical results indicate that there are relatively strong fundamentals motivating exchange rate control in order to achieve price stability. Finally, it is noticable that the estimated effects of changes in money stock, exchange rate, price level movements, and other types of economic impulses are fully consistent with the theoretical predictions of the ”classical” open macroeconomic modelling framework. The authors are grateful to John Carlson and Vera Brencic for helpful comments. The scientific notation follows the standard proposed by Abadir and Magnus (2002). Corresponding author. Address: 403 West State Street, Purdue University, West Lafayette, IN 47907-2056, USA. E-mail: [email protected]. Phone: +1 765-494-4503. Fax: +1 765-496-1778.