In this paper, we examine the relationship between the euro exchange rate and domestic inflation in the EMU area. This issue has gained importance as the euro has depreciated around 20 per cent during the first eighteen months of EMU, and is now a serious concern for the European Central Bank (ECB) since it threatens price stability in the EMU area. In the paper, we construct two simple models to illustrate the effect of the exchange rate on export demand, on the one hand, and on inflation rate, on the other hand. Export demand is explained by the exchange rate and by foreign demand, which is captured here by economic growth in the USA. The expected stimulating effect on exports from a depreciating currency does not show in the results. On the other hand, the positive effect of economic growth abroad, i.e., in the USA, shows clearly in the results. The inflation rate, in turn, is explained by the exchange rate, by domestic demand as reflected by industrial production, and by world commodity prices. The results for this equation show that a depreciation of the exchange rate clearly accelerates domestic inflation. An increase in world prices has the same effect, whereas domestic demand shows no clear effect on the inflation rate. This problem could be solved by using the output gap, instead. The most important contribution of the paper is that it applies basic models and, hence, serves as a good starting point for further research on exchange rate pass-through to domestic prices. The results indicate that the degree of pass-through could be much larger in EMU than is expected on basis of the degree of openness of the EMU economy. Thus, further research on this issue is evidently needed. – euro ; exchange rate ; inflation ; export demand ; monetary policy
