Relationship Between Inflation And Exchange Rate Economics Essay

Inflation is an increase in the price of a set of goods and services that is representative of the economy as a whole and an exchange rate is the current market price for which one currency can be exchanged for another. If the U.S. exchange rate for the Pakistani Rupee is Rs. 85, this means that one American Dollar can be exchanged for 85 Pakistani Rupees. Different journals give their opinion about relationship between inflation and exchange rate. Now we explain journal’s views about this relationship:-

Haldane (1995) [] present the design of inflation target is linked umbilical to the welfare cost of inflation. Yates (1995) [] the design of many inflation targeting regimes includes specific exception for trouble that are predictable to outcome in momentary price level actions lone. This has been observing that optimal design of inflation depends upon the costs of inflation. Depending on how agents form expectations of future inflation, direct exchange rate effects coming through import prices may result only in price level shifts. This arises perceive that a portion of the observed inflation in the CPI index is the result of changes in import prices that are drives by recent movements in the exchange rate, and they form their expectations of future CPI inflation by looking through or ignoring these effects.

Svensson (1997) [] present the objectives of monetary policy which serves to place the choice of exchange rate and inflation targeting. Monetary police can control inflation and exchange rate in the long run. In the short run monetary policy can influence the inflation that have adverse effects. Since central bank control the exchange rate and nominal exchange rate does not have an inherent significant for welfare and economic growth. The choice between an exchange rate target and an explicit inflation target should be seen as the choice between different intermediate targets in order to fulfill the goal for monetary policy. Monetary policy cannot prevent such variability in the real exchange rate. But the negative consequences of such variability can be minimized with an inflation target.

Bleaney and Fielding (1999) [] present those developing countries which peg their exchange rate achieve lower inflation. Developing countries face a trade-off choosing exchange rate regime floating the exchange rate allows the authorities greater freedom to respond to exogenous shocks, so that they achieve greater stability of output (and inflation) than under pegged rates, at the expense of higher mean inflation. The hypothesis can be attributed to the inability of developing countries to import the anti-inflation creditability of the advance countries. The widespread adoption of floating exchange rates in the developing world has had a significant cost, with faster inflation than in the typical pegged-rate country.

Evans & Lyons (1999) [] have used previous data on quotes and transactions to link up the activities of traders and asset prices over several months. They find a strong relationship between customer order flow and the DM/US$ exchange rate. A data set covering customer dealer trading and brokered interdealer trading become available, the order flow picture can be completed. The affects of increasing order-flow transparency may be important: unlike most other financial markets, the FX market is unregulated in this respect.

McCarthy (2000) [] finds that the impact of import prices and exchange rate on consumer price index in industrialized countries. The exchange rate has modest affect on domestic price inflation while import prices have a strong affect. This framework is incorporates a distribution chain of prices, has been widely adopted by a number of authors for analyzing the exchange rate pass through for various countries e.g. Leigh and Rossi (2002) for Turkey, Ashok (2002) for south Africa etc.

Taylor (2000) [] argued that pass-through is highest when exchange rate changes are perceived to be persistent and prices adjustment because of the expectations of the public. The pass-through will low because of low inflation. The pass-through changes in costs to prices, a decline that is frequently characterized as the reduction in the ‘pricing power’ of firms. The paper alludes to the relative version pf purchasing power parity, which claims that base of equilibrium exchange rate between the two currencies will be determined by the relative movements in the price levels in the two countries. Change in the exchange rate has positive relation to the higher domestic prices.

In this equation, there are E stands for exchange rate in terms of domestic currency per unit of foreign currency. Stands for foreign currency prices of the imported goods and P stands for domestic currency. When marginal cost is constant and markups of prices over costs is also constant than pass-through will be complete.

Grauwe (2000) [] analyze the implications of the view for transmission of monetary shocks. Monetary policy has different effects on the exchange rate and the price level depending on the nature of these beliefs. He claims that under the sets of beliefs that dominate the foreign exchange market, the ECB would found it difficult to control the rate of inflation.

Odusola and Akinlo (2001) [] present the existence of mixed results on the impacts of the exchange rate depreciation on the output in both medium and long term. The flexible exchange rate system does not necessary to adopt and lead the output expansion in the short-run. The discipline, confidence, creditability on the part of the government is essential. The official exchange rate shocks were followed by increases in prices, money supply and parallel exchange rate. VAR models suggested that the impacts of lending rate and inflation on the output were negative. The output and parallel exchange rate are the major determinants of inflation dynamics in Nigeria. The developments in the official exchange rate generate the positive impacts on the parallel exchange rate. It revealed that lending rate and inflation generated substantial destabilizing the impacts on the output, the monetary authority’s plays and critical role in creating an enabling environment for growth.

Choudhri, Faruqee and Hakura (2002) [] examine the performance of open economies all the way through macroeconomic models illumination the exchange rate pass-through in a extensive variety of the prices. He has been used the model based on VAR models and concludes that best-fitting models incorporate a quantity of features painted by diverse strands of the literature: sticky prices, sticky wages, allocation expenditure and a amalgamation of local and manufacturer currency pricing.

Bhundia (2002) [] analyzes the quantity to which fluctuations in the so-called exchange rate lead through to customer prices in South Africa. While the regular pass-through is established to be near to the ground, proof from a structural vector auto regression suggests it is much greater for supposed (against genuine) shocks. However, shocks to producer prices tend to have a considerable impact on consumer prices. He also found that pass-through is much higher for nominal rather than real shocks. The Rossi (2002) finds that the pass-through from the exchange rate to domestic prices continues for a year but is more intensive in the first four months, the pass-through to WPI is more pronounced than CPI, forecast of inflation. Rabnal also prove that pass-through to WPI is more pronounced than pass-through CPI.

McFarlance (2002) [] present the affects of exchange rate changing on one of the following (1) import & export prices (2) consumer prices (3) investment and also (4) trade volumes. The previous study on Jamaica tells that the pass-through on prices and wages are significant. The inflationary impact of exchange rate depreciation in Jamaica has declined in recent years. Pass-through to the CPI is approximately 80% complete six months after initial shocks to the nominal exchange rate for the 1990 to 1995. And than after pass-through is less complete at approximately 45% in the 1996 to 2001 six months after an initial shocks to the nominal exchange rate. In addition to, the pass-through to CPI excluding starchy in agriculture to the CPI over the two sub-samples. The pass- through is approximately 70% in 1990 to 1995 complete six months after an initial shock to the nominal exchange rate. These results show that the speed of the pass-through has slowed significantly in the last five years. This situation shows the lower demand and structural transformation in the Jamaica’s economy. Additionally there has been increased competition in the domestic economy: this coupled with the fall in output following the financial crises of the mid to late 1990’s would have had an impact on per capita income and hence aggregate demand.

Carr and Rebello (2002) [] analyze the feasibility and complication of inflation targeting in the developing countries. There is wealth of econometrics attempting to demonstrate the success of various inflation regimes at decreasing inflation. The success of a county is in low inflation. Taylor (1991) shows the monetary authorities react to other variables besides inflation, such as output and exchange rate. Stylized facts indicate that a common implication of inflation targeting is an appreciating exchange rate due to capital inflows. The exchange rate appreciation is the result of inflation targeting with open capital markets. If prices are set as a markup over costs, than prices will be quite sensitive to changes in the exchange rate. The exchange rate affects the equilibrium of the iso-inflation curve. The increase in capital inflows causes the exchange rate to appreciate. The ultimate rate of inflation depends on the relative affects of the exchange rate, interest rate, and output. The inflation rate, exchange rate and interest rate dynamics evolve over time given initial short run equilibrium conditions.

Berument and Pasaogullari (2003) [] have reviewed in their study, that there is negative relationship between output and real exchange rate in Turkey. They analyzed that their exist long-term negative relationship between inflation and exchange rate and output. They run different VAR models and estimate the forecast error variance decompositions and impulse responses obtained from the VAR models were examined and they also analyzed the bivariate relationship between the set of the variables of interest. However, from Granger causality test, a significant causality between the variables could not be found. They found that a long-run relationship exists among inflation, exchange rate and output, which led us to employ VAR models. After including different variables in VAR models like real exchange rate, inflation, output, interest rate, capital account and current account real exchange rate movements were proved to be important in the variability of output. They suggest that to limit the detrimental effects of devaluation, the overvaluation of the currency must be prevented, and there is no easy way to keep output costs at moderate levels after devaluation. These finding suggest that an overvalued domestic currency may initially result in increased output but may create the risk of a financial crisis, which, in turn, may cause exchange rate depreciation and subsequent output losses.

Carranza and Sanchez (2004) [] explain the pass-through between exchange rate and inflation with the degree of dollarization. They suggest that those countries which have high dollarization demonstrate greater pass-through coefficients. With the use of fifteen samples emerging-market countries with the different degrees of dollarization , they find that pass-through in highly dollarized economies is indeed higher, but it also tend to be more asymmetric than in economies with a lower degree of dollarization. They define that there is negative pass-through coefficient during economic downtime. The reason for this irregularity is the unconstructive balance-sheet result that can lead the constructive competition effect generated by real exchange rate depreciations.

Honohan and Lane (2004) [] argued that exchange rate movements have important effects on inflation divergence within the EMU. The inflation rates of euro appreciation (2002-2003) as well as periods of euro depreciation (1999-2001). According to Irish case: in 2003 the pass-through of inflation and exchange rate was already under way and consumer price inflation stopped in its tracks. Inflation fell to zero in response to the strengthening of the euro vis-à-vis the dollar. There is lagged correlation between Irish CPI inflation and the level of nominal effective exchange rate. They suggest the variety of regressions to exp-lain annual inflation differentials across the Euro zone over the 1999-2001 periods. They found the variations in nominal effective exchange rate movements explaining divergent inflation rate during this period, although the HICP data suggest that this largely operates via the influence of exchange rates on national output gaps. The exchange rate channel is strongly significant for each of the inflation measures. There is also some evidence of asymmetries in that exchange rate depreciation passes through into inflation more quickly than does exchange rate appreciation. Finally our analysis with quarterly data 1999.1-2004 confirms the powerful connection between exchange rate and inflation. with the passage of time, it should be possible to construct a more complete accounting of the dynamic structure of the relationship between these variables than is possible with only five years of data.

Rutasitara (2004) [] explains that Tanzania in 1960s faced the inflation and there has been interest, therefore, in inflation performance and the role of the exchange rate in the process. When inflation rate rise, then erode the value of money holdings, trade flows, investors confidence etc. the controls covered prices (including wages, interest rate, goods prices, and exchange rate) and allocation of domestic credit and foreign exchange, the exchange rate became prominent in the policy debate on the internal and external imbalances. Until then, the parallel exchange rate had an upper hand on the rate of inflation compared with the official exchange rate. The impact of foreign prices and exchange rate depends upon existing pricing arrangements, which in Tanzania have ranged from controls to “markets”. While a more or less “stable” nominal exchange rate is desirable for trade and investment decisions, it is more important to maintain the rate at sustainable levels. The level and prospects of the foreign reserves position are important in this respect. The exchange rate remains precariously sensitive and easily vulnerable to exogenous shocks, domestic economic factors, and non-economic events like social and political instability that may generate a desire to shift financial assets into a foreign currency considered to be more secure.

Bleaney and Francisco (2004) [] define that if the monetary authorities adopt an accommodatory stance by allowing the money supply to respond more to the price shock, then inflation will be more persistence. Smith (1991), Alogoskoufis (1992) and Obstfeld (1995) compare persistence estimates for OECD countries over different periods characterized by different exchange rate regimes. When monetary authorities in the OECD countries began to recognize that a tough response to inflation shocks was necessary to keep inflationary expectations down. Our results show that inflation persistence is much the same under soft pegs as under floating. It is significantly lower under hard pegs (currency boards or a shared currency), where the scope for monetary accommodation of inflation shocks is much reduced.

Adolfson (2004) [] suggest that the pass-through from exchange rate changes to prices in Swedish currency of imported goods is discussed as well as conceivable reasons for why these changes are not passed through completely in the short-run. The inflation rate in Sweden had recently been low.

inflation = weight x domestic inflation +(1-weight ) x imported inflation

Where weight is domestic inflation’s share of total inflation. As a result, conditions in Sweden will also affect imported inflation, not only via the exchange rate but also through an impact on foreign exporters’ prices for Swedish importers. The relative significance of the exchange rate and world market prices for Swedish import prices is difficult to determine, however, since it is rare that data is available that would enable a comparison of the price of a certain product in the Swedish market. Rather, the recent fall in import prices seems to be largely attributable to exchange rate developments. T5hus in the short-run, the pass-through from exchange rate changes to Swedish import prices appear to be limited. There is weak relationship between exchange arte and prices in the foreign market.

Bailliu and Fujii (2004) [] argued that credible monetary policy play an important role to decrease the inflation in industrialized countries. Many industrialized countries that the extant of pass-through of exchange rate into buyer prices has turned down. They argued that ERPT is primarily a function of the persistence of exchange rate and price shocks, which tend to be reduced in an environment where inflation is low and monetary policy is more credible. Using the data of 11 developed countries more than the period from 1977-2001, they evidence to support the hypothesis that EPRT declines with a shift to a low-inflation surroundings bring about by modify in the financial policy control. The consequence proposes that pass-through to import; manufacturer and consumer price inflation reduces following the inflation stabilization that occurred in most of the developed countries in the early 1990s.

Ruiz (2005) [] in this study describes the effects of inflation and exchange rate uncertainty on the rate of real economic activity. He explains in his literature that these two issues and discrete issues. Note whether the frequency of inflation or the frequency of exchange rates on economic growth in the various actions or financial activity. In this paper, the author tries to address these issues by analyzing the size and direction of the effect of: inflation and the frequency in the exchange rate on real economic activity. Through the introduction of dummy variables and control of monetary policy change (change of inflation targeting and flexible exchange rate).  Autoregressive using a variety of conditional (GARCH) rates of inflation and exchange rates, and predictive models obtained conditional variance errors and measures of uncertainty. The study results indicate that the increase in the higher level of uncertainty, causing inflation farms, and vice versa for the Colombian economy. In addition, the issue of inflation just to get out of the frequency of negative impact.

Goldstein and Lardy (2005) [] define as the weight of emerging economies in the global economy has increased. This is particularly the case with china’s exchange rate policy since it is now the world’s third largest importer and fourth largest exporter. Thus, any adjustment of China’s exchange rate regime will have to maintain most existing capital controls until the domestic banks are further strengthened. China could simultaneously and immediately remove the restrictions on capital flows and let the market determine value of the RMB. The constraints mean the search is for second-best policy options. International codes of conduct for exchange rate policy are no less necessary than those for trade policy; without them, there can be a free-for-all that is in no one’s interest, least of all the emerging economies that depend so heavily on access to international markets. Currency manipulation is not a narrow academic issue, akin to how many angels can fit on the head of a pin. It is instead a legitimate practical concern in establishing a level international playing field.

Grauwe (2005) [] gives their views on the relationship between inflation and exchange rate that exchange rate regime and inflation is that pegged exchange rate contribute to lower and more stable inflation. The exchange rate fixity does not reduce economic growth in the South Eastern and Central European countries. In countries, with strong institutional framework (based on central bank independence and developed money markets), low inflation can be achieved without any specific commitment to an explicit exchange rate target. In large (closed) economies, inflation targets-which imply freely floating exchange rates-will not affect the volatility of inflation. On the contrary, by fixing exchange rates to the euro, the countries at the EMU periphery can reap the benefits of more trade and lower interest rates. The view that entry into the euro area will constrain the growth potential is not warranted. The evidence also shows that for these small, open economies, stabilizing exchange rates has been a source of macroeconomic stability. The Mundell framework seems to be the right one to use in thinking about the desirability of joining the euro area. The risk of to join the EMU will be particularly strong, if labor marker flexibility is low.

Vargas (2005) [] explains monetary policy in Colombia converged to a pure, full-fledged inflation-targeting strategy after the abandonment of exchange rate bands in 1999. Colombia had experienced moderate inflation (15-30 percent annual rates) for about 20 years and a crawling-peg regime with capital controls had been in place since 1967. In the context of a monetary policy strategy based on the use of intermediate monetary targets. Thus, a floating regime was established and monetary policy converged to a full-fledged inflation-targeting framework. Monetary and foreign exchange policy had two main initial objectives. The first was to continue gradual disinflation toward its long-term target and the second was to restore international reserves to levels that would limit the external vulnerability of the economy. Starting from a deep recession, the policy stance has been expansionary. Inflation has declined along decreasing targets, output has recovered and international reserves have reached levels that limit the external vulnerability of the economy. The most convincing hypothesis about the rationale for intervention in Colombia is the argument in favor of managed floating. Thus, fiscal imbalances pose a threat to the credibility and power of monetary policy through several political economy channels.

Angkinand and Willet (2006) [] Studying the effects of the choice of exchange rate regimes on the likelihood of financial crisis in a sample of a very talented market and developing countries for the period 1990-2003. It is a multi-channel testing of potential impacts of exchange rate regimes to crises. They found that soft Pegs associated with other central systems with high potential economic crises of the regulation reform difficult corner and rates are very flexible, and partly because it seems to be associated with more loans in foreign currency are not protected and extension extreme credit of the Interior. Also affect the test through the channel of the monetary crises caused by the strong relationship between monetary and financial crises, and between the soft Pegs and monetary crisis. These effects are much stronger in the market, the increase in developing countries.

Allsopp, Kara and Nelson (2006) [] define the United Kingdom’s monetary policy strategy can be characterized as one of floating exchange rates and inflation forecast targeting. The specification of exchange rate and inflation relationship implied by “standard” New Keynesian models, which postulate that imports serve as finished consumer goods, is inconsistent with the U.K empirical evidence. It is a well-known principle in the New Keynesian literature that the index whose inflation rate is targeted should refer to the set of prices which are sticky and which prevent the instantaneous achievement of the flexible-price equilibrium. The broader policy implications arise from the way in which openness is modeled and the way in which exchange rate changes impact on inflation. In the standard model, there is a direct and immediate effect on the price of imported consumer goods, which then impacts directly on inflation. When imports are intermediate goods, following the specification used and recommended by McCallum and Nelson (1999), the U.K. evidence can be reconciled with optimizing theory. In particular, the weak relationship observed between consumer price inflation and exchange-rate changes, despite strong rates of pass-through, can be rationalized. Furthermore, this modeling strategy implies that it is appropriate to target consumer price inflation. Monetary policy regimes do matter for the exchange rate/inflation relationship, but not in the manner argued in the literature. Several studies have appealed to the role of monetary policy regime in blocking the pass-through of exchange-rate movements to imported goods prices. The U.K. evidence instead is consistent with substantial pass-through to import prices across regimes. Adjustment of the relative price of imports is often a desirable response to real shocks hitting the economy. To some extent, this adjustment may be facilitated by permitting a one-time rise in the aggregate price level even if at the cost of inflation temporarily moving away from the target. The U.K. experience under inflation targeting, however, suggests that only minor deviations of inflation from target would be required for this purpose. the exchange rate should be taken into account only via their influence on the forecast for consumer price inflation are open to the criticism that standard models suggest that consumer prices constitute too broad an index to target, and that the imported component should be removed from the targeted inflation rate. A properly-measured output gap (i.e. one which takes into account the negative impact on potential output of a higher real cost of imports) is an adequate summary of the implications of exchange-rate movements for welfare.

Edwards (2006) [] says that in many countries the nominal exchange rate is often used as a means of curb inflation. Currency crisis are common, and usually the result of acute (Real Madrid), excessive exchange rate. It affects inflation, exports, imports and economic activity. For decades the vast majority of emerging countries had rigid exchange rate regimes. This move away from exchange rate rigidity has tended to take place at the same time as many countries have embraced inflation targeting as a way of conducting monetary policy. The conjunction of IT and flexible rates has brought to the center of the discussion a host of new policy issues, including issues related to the role of the exchange rate in monetary policy, volatility and the relationship between exchange rate changes and inflation. He addressed three of this issues: (a) the relationship between the pass-through and the effectiveness of nominal exchange rates in IT regimes; (b) the effects of IT on exchange rate volatility; and (c) the role (or potential role) of exchange rate changes on the monetary rule in IT countries. Countries that have adopted IT have experienced a declined in the pas-through from exchange rate changes to inflation. In many of the countries in the sample this decline in the pass-through has been different from CPI inflation than for PPI inflation. The adoption of IT monetary policy procedures has not resulted in an increase in (nominal or real) exchange rate volatility. there is some evidence that IT countries with a history of high an unstable inflation tend to take into account explicitly developments in the nominal exchange rate when conducting monetary policy.

Kamin (2006) [] Describes the comparative research between the response to changes in inflation rates in competitive exchange rates in various regions of the world. The report shows that the empirical relationship between inflation and the level of real exchange rate, which has been documented in Mexico earlier research by the author, covering a wide range of other countries. This can be a dilemma for policy makers because it means you cannot lower inflation and increase the competitiveness of exports access to the same time. In response to the inflation of the real exchange rate is much higher in Latin America, Asia or in industrialized countries. This difference in the responsiveness of inflation is not a full explanation of the date of inflation or the degree of openness to foreign trade. It may be less sensitive to inflation, real exchange rate in Asia than in Latin America is going to allow Asian countries continues to focus on always maintaining competitiveness and export growth.

Bjornstad and Jansen (2007) [] define that Norway adopted a flexible inflation target in March 2001. Before 2001 Norway followed various exchange rate targets, first targeting a trade weighted basket of currencies (1978-1990) with several small realignments and a final big devaluation in May 1986. An absence of international currency crises there has been greater variation in the nominal exchange rate. The empirical correlations suggest that an increase in the Norwegian interest rate relative to that of the euro zone weakens the Norwegian Krone in the short run. In an exchange rate targeting regime the interest rate is rarely used and only to counteract large movements in the exchange rate after interventions have failed to stabilize the exchange rate. When the central bank targets the exchange rate, interest rates are rarely used and only to counteract large movements in the exchange rate when interventions have failed. With inflation targeting the interest rate is used to stabilize the domestic economy and the exchange rate responds strongly to interest rate changes with the expected sign. The effect of an interest rate change on the exchange rate may be different and stronger if it comes as a surprise to the agents compared to the case where it is anticipated.