Exchange Rate Pass-Through in a Structural Small Open Economy Model: How Important is the Conduct of Monetary Policy

Several authors have presented reduced-form evidence suggesting that the degree of exchange-rate pass-through to the consumer price index has declined in Canada since the 1970s and is currently close to zero. Authors such as Taylor (2000) suggest that this is due to a change in the conduct of monetary policy. Specifically, if monetary policy is seen to be responding more aggressively to shocks that affect inflation then the expected persistence of these shocks will decline and by consequence, so will the degree of pass-through to consumer prices. This paper investigates the extent to which monetary policy, under commitment to inflation targeting, can influence exchange rate pass-through in a dynamic stochastic general equilibrium model of a small open economy. We begin by defining pass-through in the context of a reduced-form Phillips curve and then compute numerically the relationship between pass-through and the parameters of a simple policy rule. We then investigate the extent to which reasonable changes in the aggressiveness of policy, such as those observed since the 1970s in Canada, could account for the observed decline in pass-through. The model presented here assumes that imports serve as an input to the home economy's production process. Pass-through of the exchange rate to import prices is incomplete in the short run due to the existence of multi-period price contracts denominated in the home currency.