Exchange rate pass-through in to inflation: New insights in to the cointegration relationship from Pakistan

Understanding the impact of exchange rate movements on prices is critical from a policy perspective in order to gauge the appropriate monetary policy response to currency movements. This study assesses the extent to which the movements in exchange rate affect domestic consumer prices in Pakistan by analyzing quarterly data from 1982 Q1 to 2010 Q4. The structural VAR (SVAR) model is used to estimate the exchange rate pass‐through to inflation in Pakistan. Further, impulse response function and variance decomposition are used to measure the exchange rate pass-through to domestic prices. The major findings of this study are as follows: (i) the exchange rate movements have only a moderate effect on domestic prices, (ii) for consumer prices, ERPT elasticity is around 0.042 in the short run and 0.137 in the long run, (iii) up to 90% of the price level changes are explained by its own shocks in the long run. The study concludes that the effect of an exchange rate shock on domestic prices is quite gradual, taking about 14 quarters to arrive at the full impact. The immediate effect of a structural one standard deviation shock to the exchange rate (which is 0.045 increase, or 4.5% appreciation) is about 0.001 (or 0.1%) decrease in the price level. This entails an impact elasticity of 0.042. The full effect of this shock, realized after about 14 quarters, is about 0.0062 (or 0.62%) decrease in the price level. This implies a dynamic pass-through elasticity of 0.137. The result highlights the importance of other factors that play significant roles in the Pakistan's inflationary process, e.g. supply shocks.