The 24 reference contexts in paper Jeannine Bailliu, Eiji Fujii (2004) “Exchange Rate Pass-Through and the Inflation Environment in Industrialized Countries: An Empirical Investigation” / RePEc:bca:bocawp:04-21

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    smaller than expected.3 This common experience has led to the belief, shared by central bankers in many industrialized countries, that the extent of exchange rate pass-through (ERPT) into consumer prices has declined. Furthermore, the fact that this potential decline has coincided with a transition to a lowinflation environment has popularized the view that these two phenomena could be linked.
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    Taylor (2000)
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    was one of the first to formally articulate this view and put forth the hypothesis that the 1.Other possible factors include favourable shocks, structural change, and increased international competition. 2.
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    Taylor (2000) was one of the first to formally articulate this view and put forth the hypothesis that the 1.Other possible factors include favourable shocks, structural change, and increased international competition. 2.See
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    Longworth (2002)
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    for a review of how Canadian monetary policy was able to deliver lower and more stable inflation in the 1990s compared with the previous decade. 3.Laflèche (1996) finds that special factors—such as the restructuring of the retail market, the abolition of customs duties on trade between Canada and the United States, and weakness in the aggregate economy—played an important role in explaining this o
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    She also suggests that the adoption of inflation targeting in 1991, and the resulting move to a low-inflation environment, may have been a contributing factor. This view is also supported by econometric evidence. Indeed, both Fillion and Léonard (1997) and
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    Kichian (2001)
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    found evidence that, compared to previous decades, the exchange rate pass-through (ERPT) coefficient in a Phillips curve model for Canada fell in the 1990s. low-inflation environment in many industrialized countries, which was brought about by more credible monetary policies, has successfully reduced the degree of ERPT to domestic prices.
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    In the NOEM literature, based mainly on work by Obstfeld and Rogoff (1995), nominal rigidities and market imperfections are introduced into a dynamic general-equilibrium (DGE), open-economy model with well-specified microfoundations. Although PPP holds and pass-through is complete in the framework originally presented by Obstfeld and Rogoff, Betts and
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    Devereux (1996, 2000)
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    extended this model to allow for pricing to market, and therefore incomplete pass-through. In this type of framework, ERPT will depend on different pricing strategies, such as whether the firm practises producer currency pricing (PCP) or local currency pricing (LCP).
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    In this type of framework, ERPT will depend on different pricing strategies, such as whether the firm practises producer currency pricing (PCP) or local currency pricing (LCP). As discussed by Betts and
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    Devereux (1996) and Engel (2002),
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    if prices are preset in the currency of the producer, then the home-country price of the foreign good will move one-for-one with changes in the nominal exchange rate; thus there is full pass-through. Consequently, exchange rate movements will lead to a change in the relative price of the goods, and this will lead to a change in consumers’ demand for home, relative to foreign, goods.
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    On the other hand, if a firm practises LCP, then prices are preset in the local currency, and changes in the nominal exchange rate will have no short-run effect on prices faced by consumers. Thus, there is no pass-through in the short run. 7.Goldberg and
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    Knetter (1997)
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    provide a comprehensive review of this literature. 8.For example, see Kreinin (1997) and Hooper and Mann (1989). 9.For example, see Marston (1990) and Krugman (1987). If the economy is best characterized by a combination of firms, some of which practise LCP and some of which follow PCP, then the aggregate degree of pass-through will be partial in the short run.
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    On the other hand, if a firm practises LCP, then prices are preset in the local currency, and changes in the nominal exchange rate will have no short-run effect on prices faced by consumers. Thus, there is no pass-through in the short run. 7.Goldberg and Knetter (1997) provide a comprehensive review of this literature. 8.For example, see
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    Kreinin (1997) and
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    Hooper and Mann (1989). 9.For example, see Marston (1990) and Krugman (1987). If the economy is best characterized by a combination of firms, some of which practise LCP and some of which follow PCP, then the aggregate degree of pass-through will be partial in the short run.
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    Thus, there is no pass-through in the short run. 7.Goldberg and Knetter (1997) provide a comprehensive review of this literature. 8.For example, see Kreinin (1997) and Hooper and Mann (1989). 9.For example, see
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    Marston (1990) and Krugman (1987).
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    If the economy is best characterized by a combination of firms, some of which practise LCP and some of which follow PCP, then the aggregate degree of pass-through will be partial in the short run. This is consistent with evidence that suggests that the ERPT varies by industry.10 The assumption that firms in the economy may follow different pricing strategies has also been advanced as an explanatio
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    firms—who assemble the imported goods and sell final goods to consumers—prefer to price in the local currency (because they face significant competition from other domestic final goods producers). The NOEM literature has also examined the extent to which ERPT can depend on a country’s inflation performance or monetary policy. As discussed earlier, this work is based on an idea put forth by
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    Taylor (2000),
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    who argued that a shift to a low-inflation environment causes a decline in the expected persistence of cost and price changes, which in turn results in a decline in ERPT. More specifically, several recent papers have developed NOEM-DGE models highlighting the link between pass-through and monetary policy.
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    as a decline in the expected persistence of cost and price changes, a fall in the frequency of price changes, or an increase in the prevalence of LCP, these studies show that a transition to a low-inflation environment—that comes about as a result of a more credible/stable monetary policy—can lead to a lower degree of ERPT. Choudhri and Hakura (2001) emphasize a channel similar to the one in
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    Taylor (2000)
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    in the context of a DGE model with imperfect competition and staggered contracts. In their model, a low-inflation regime reduces ERPT because the pass-through reflects the expected effect of monetary shocks on current and future costs, which, in turn, are reduced by having a low-inflation regime.
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    If prices are sticky in the currency of the exporter, and thus there is a predominance of PCP in the economy, then ERPT will tend to be high. On the other hand, if goods prices are preset in the consumer’s currency (consistent with 10.See, for example, Campa and
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    Goldberg (2002).
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    LCP), then ERPT will tend to be low. Pass-through is linked to monetary policy in that countries with relatively stable monetary policies are assumed to have a prevalence of LCP in the economy. The relationship between ERPT and the inflation environment has also been examined empirically in a handful of studies.
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    Indeed, in addition to using a cross-sectional approach, as do Choudhri and Hakura (2001) and Devereux and Yetman (2002), they also test whether pass-through declined in each country in the sample following a change in the inflation regime.12 One regime change was identified for each 11.Campa and
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    Goldberg (2002)
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    use a similar approach in their study of pass-through in Organisation of Economic and Co-operation Development (OECD) countries, although they focus on import rather than on consumer prices. Although they also find a positive association between inflation and ERPT, they conclude that microeconomic factors related to the composition of imports are relatively more important in explaining cross-count
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    Indeed, the traditional definition of ERPT is the percentage change in the local currency price of an imported good resulting from a 1 per cent change in the nominal exchange rate between the exporting and importing countries. This definition has now been expanded to include other types of prices, notably consumer prices. 15.See, for instance,
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    Dornbusch (1987), Knetter (1989), and Marston (1990).
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    q ,(2) psCqμ= Cqμ μηη1–()⁄≡η where is the marginal cost and is the markup of price over marginal cost. The markup is further defined as, where is the price elasticity of demand for the good.16 The expression for the price level in equation (2) emphasizes that the local currency price of the good can vary as a result of a change in the exchange rate, a change in the firm’s marginal cost, and/or a c
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    Consequently, a simple log-linear, reduced-form equation may be expressed as follows: ,(3) ptαλstτwtηytεt++ + += where and are measures of the exporter’s marginal cost and the importing country’s wtyt λ demand conditions, respectively. The coefficient thus measures ERPT. As discussed in Goldberg and
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    Knetter (1997),
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    variants of equation (3) are widely used as empirical specifications in the pass-through literature. In adapting this specification to be suitable for estimating ERPT at the aggregate level for all three price indexes, there are several issues that need to be considered.
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    However, as a result of the fact that the lagged dependent variable is correlated with the disturbance term, the problem is that these estimators (when applied to dynamic models) are biased in finite samples. Indeed, as shown by
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    Nickell (1981),
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    the standard estimators for a dynamic panel-data model with fixed effects generates estimates that are biased when the time dimension of the panel is small.23 To address this issue, we use a dynamic GMM panel-data estimation developed by Arellano and Bond (1991) based on work by Anderson and Hsiao (1981) and Holtz-Eakin, Newey, and Rosen (1988).
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    all available lagged values of the dependent variable with 23.And as Judson and Owen (1999) have shown using a Monte Carlo approach, this bias can be sizable even when the number of observations per cross-sectional unit (T) reaches 20 and 30. Therefore, given that our panel-data set has T = 25, estimating equation (4) using the standard fixed-effects model would yield biased estimates. 24.
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    Arellano (1989) and
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    Arellano and Bond (1991) subsequently showed that it is better to use the lagged level than the lagged difference as an instrument, given that the latter results in an estimator with a very large variance. ()yit1–,yit2–,– yit2–,yit2–,yit3–,– ()εit,εit1–,–yit1–,yit2–,–() current and lagged values of the differences of the exogenous variables into a large instrument matrix; their GMM estimator then
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    of the trade-weighted nominal exchange rate in industrialized countries leads to, on average, a 0.75 per cent increase in the annual rate of inflation of import prices in that same year, and a 0.91 per cent increase in the long run.30 These results are in line with estimates in the literature of exchange rate pass-through into import prices for industrialized countries. For instance, Campa and
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    Goldberg (2002)
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    find that the average rate of pass-through into import prices across their sample of 25 OECD countries over the period 1975–1999 is 0.61 in the short 30.As discussed in Bailliu and Bouakez (2004), the import price series for Canada—one of our sample countries—suffer from measurement error in that a number of Canadian import prices are constructed by multiplying the foreign currency price by the no
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    effects on the estimation results to be negligible. run and 0.77 in the long run.31Moreover, they find that partial pass-through is the best description for import price responsiveness in the short run (which, in their case, is one quarter), whereas full pass-through is generally supported as a longer run characterization.32 And in his study of exchange rate pass-through in euro-area countries,
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    Anderton (2003)
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    finds a pass-through rate of between 0.5 and 0.7 for extra-euro area imports. Our estimates are thus generally consistent with these results. We do find a higher degree of exchange rate pass-through in the short run, but this can be explained by the fact that the short run refers to one quarter in their studies, whereas it spans one year in our analysis.
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    Belgium1985Q1After Belgium joined the European Monetary System (EMS) in 1979, there were frequent downward realignments of the Belgian franc until the mid-1980s, when Belgium started pursuing “a progressively tighter exchange rate policy”
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    (Halikias 1993,
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    1). Canada1982Q3As was the case in the United States, the Bank of Canada raised interest rates substantially in the early 1980s in order to reduce inflation. See Freedman (1982) for more details. This period also coincided with the end of the practice of targeting monetary aggregates at the Bank of Canada (officially cancelled in November 1982).
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    Belgium joined the European Monetary System (EMS) in 1979, there were frequent downward realignments of the Belgian franc until the mid-1980s, when Belgium started pursuing “a progressively tighter exchange rate policy” (Halikias 1993, 1). Canada1982Q3As was the case in the United States, the Bank of Canada raised interest rates substantially in the early 1980s in order to reduce inflation. See
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    Freedman (1982)
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    for more details. This period also coincided with the end of the practice of targeting monetary aggregates at the Bank of Canada (officially cancelled in November 1982). Canada1990Q4The adoption of inflation targeting in Canada was announced in February 1991.
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    Policy Change (cont.) CountryDatePolicy Change France1985Q1Several important changes were made to French monetary policy from 1983 to 1987, including the adoption of a policy of competitive disinflation (which began in 1983 but took several years to complete) and a major reform of French financial markets that profoundly changed the operating procedures of French monetary policy. See
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    Mojon (1999)
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    for more details. France1992Q1France successfully defended its peg during the EMS crisis in 1992, demonstrating its commitment to the EMS and the impending European monetary union. United Kingdom 1982Q1Starting in mid-1979, monetary policy shifted significantly in the United Kingdom towards a much more restrictive policy aimed at bringing about a disinflation through higher interest rates.
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    Following the breakdown of the Bretton Woods system, the Dutch authorities decided to stabilize the guilder in terms of the Deutsche Mark. Although there were several devaluations in the 1970s, the peg stabilized in the early 1980s (the last devaluation was in 1983). See
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    Hilbers (1998)
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    for more details. United States 1981Q2Paul Volker was appointed Chairman of the Federal Reserve in 1979 and orchestrated a disinflation by raising interest rates (they peaked in early 1981). United States 1990Q4A shift in U.
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    United States 1990Q4A shift in U.S. monetary policy in the 1990s has been identified and characterized as one in which the Federal Reserve responded more aggressively to rising inflation than in previous decades (see
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    Mankiw (2001)
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    for more details). flexible version of inflation control. And finally, most of the European countries continued to rely on exchange rate pegs as a means of importing the low inflation rate of the core country of the Exchange Rate Mechanism (ERM), Germany. 5.2Panel pass-through estimates in different inflation environments Based on these identified structural breaks, we constructed the two dummy va
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    This could be due to the fact that many of the sample countries made more substantial reforms to their monetary policy regimes in the latter decade (for example, by adopting inflation targeting). Moreover, as discussed in
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    Paulin (2000),
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    the 1990s were characterized by a period in which central banks acquired greater operational independence to pursue their policy objectives and became more open institutions. This trend most likely contributed to increasing both the effectiveness and credibility of policy actions.
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