Does Weak Business Confidence Impact the Pass-Through of the Exchange Rate Depreciation Shocks to Inflation?

Abstract

Evidence reveals that the weak business confidence (including post 2008Q1), reduces the correlation between the exchange rate changes and inflation, and the size of the ERPT to inflation. In addition, inflation increases less to exchange rate depreciation shocks when the 3% and 4.5% inflation threshold are used compared to the 6% inflation threshold, which indicates inflation regimes matter. In addition, the subdued GDP growth post 2008Q1 accentuated the impact of weak business confidence in lowering the correlation between the exchange rate changes and inflation. Therefore, the subdued demand side inflationary pressures and low inflation regime play an important role in the transmission of exchange rate depreciation shocks to inflation. This suggests that the inflationary risk from currency depreciation maybe less severe when the business confidence index is below 50 points.