(WP 2010-05) Exchange-Rate Pass Through, Openness, and the Sacrifice Ratio

Considerable recent work has reached mixed conclusions about whether and how globalization affects the inflation-output trade-off and suggests that the ultimate effect of openness on the output-inflation relationship is influenced by a variety of factors. In this paper, we consider the impact of exchange-rate pass through and how pass through conditions the effect of openness on the sacrifice ratio. We develop a simple theoretical model showing how both the extent of pass through and openness can interact to influence the output-inflation relationship. Next we empirically explore the nature of these two variables and their interaction. Results indicate that greater pass through increases the sacrifice ratio, that there is significant interaction among pass through and openness, and?once the extent of pass through is taken into account alongside other factors that affect the sacrifice ratio, such as central bank independence?openness exerts an empirically ambiguous effect on the sacrifice ratio.