Monetary Policy and Exchange Rate Pass-through: 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

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

25. Firm’s Optimization: Nominal Real

26. Flexible prices Set price one period in advance

27. ONE-PERIOD NOMINAL RIDIGITY

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?

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.