Revisiting the Exchange Rate Pass-Through: A General Equilbrium Perpespective

A large literature estimates the exchange rate pass-through to prices (ERPT) using reduced-form approaches, whose results are an important input at Central Banks. We study the usefulness of these empirical measures for actual... [ view full abstract ]

A large literature estimates the exchange rate pass-through to prices (ERPT) using reduced-form approaches, whose results are an important input at Central Banks. We study the usefulness of these empirical measures for actual monetary policy analysis, emphasizing two main problems that arise naturally from a general equilibrium perspective. First, while the literature describes a single ERPT measure, in a general equilibrium model the evolution of the exchange rate and prices will differ depending on the shock hitting the economy. Accordingly, we distinguish between conditional and unconditional ERPT measures, showing that they can lead to very different interpretations of the likely dynamic of prices after a given change in the exchange rate. Second, in a general equilibrium model the ERPT crucially depends on the expected behavior of monetary policy, but the empirical approaches in the literature cannot account for this. Thus, relying on these measures as a guide for monetary policy analysis is equivalent to believe that the final outcome will be independent from policy. We quantitatively evaluate these distinctions by means of a DSGE model of a small and open economy with sectoral distinctions, real and nominal rigidities, and a variety of driving forces; estimated using Chilean data.