A quarter century of inflation targeting & structural change in exchange rate pass-through: Evidence from the first three movers

Abstract

This study analyses the implications of Inflation Targeting (I.T.) for the Exchange Rate Pass-Through (ERPT) to inflation and trade balance by focusing on the first three movers i.e. New Zealand, UK and Canada. Drawing on the monthly data from October 1976 to September 2017, we employ a TVSVAR framework. Our key findings suggest that there is significant evidence of time-variation in the ERPT to inflation and trade balance in all three countries. Contrary to the notion that the ERPT to inflation has decreased under inflation targeting, in fact, there is strong evidence that if there is anything, it is the other way round. The ADF unit root test with a structural break suggests that the oscillations in coefficients for inflation show a decrease and timing corresponds with the start of I.T. However, this coincident cannot lead to infer that the ERPT has lost its significance. There is also a considerable amount of heterogeneity in the ERPT in the under-analysis countries. Specifically, in response to the positive Real Effective Exchange Rate (REER) shock, the inflation fell in the UK and New Zealand whereas, in Canada, it had the opposite effect. On the ERPT to the trade balance, the results on the UK showed clear evidence of J-curve whereas in Canada, the impact was rather instantaneous, and the trade balance quickly deteriorated. In New Zealand, the trade balance also showed deterioration in response to the REER shocks, although comparatively there was milder response than Canada and the UK. Our findings have profound implications for monetary policy formulation under I.T. regimes and the influence of ERPT on price stability and external balance.