N° 826 Revisiting the Exchange Rate Pass Through: A General Equilibrium Perspective
Authors: Mariana García-Schmidt y Javier García-Cicco
Categoría: Working Papers

The Working Papers series of the Central Bank of Chile disseminates economic research conducted by Central Bank staff or third parties under the sponsorship of the Bank. The purpose of the series is to contribute to the discussion of relevant issues and develop new analytical or empirical approaches in their analyses. The only aim of the Working Papers is to disseminate preliminary research for its discussion and comments. Publication of Working Papers is not subject to previous approval by the members of the Board of the Central Bank. The views and conclusions presented in the papers are exclusively those of the author(s) and do not necessarily reflect the position of the Central Bank of Chile or of the Board members.

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Technical Summary

A large literature estimates the exchange rate pass-through to prices (ERPT) using reducedform approaches, whose results are an important input for analyses at Central Banks. We study the usefulness of these empirical measures for actual monetary policy analysis and decision making, 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. 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 and thus provide a misleading guide for policy makers. We first use a simple model of a small and open economy to qualitatively show the intuition behind these two critiques. We then highlight the quantitative relevance of 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.

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