Drivers of consumer prices and exchange rates in small open economies

Abstract

We study the fluctuations of exchange rates and consumer prices in two small open economies with large foreign dependence, Sweden and Canada, using structural Bayesian VARs with zero and sign restrictions. For both economies, we find that the main drivers of consumer price inflation are global demand shocks, i.e. global temporary shocks that generate a positive comovement between foreign output and foreign inflation, including shocks to monetary policy abroad. Negative global demand shocks are not only deflationary for small open economies, but also induce an exchange rate depreciation. Hence, the observed exchange rate pass-through following these shocks is of opposite sign to what is usually expected. Finally, exogenous shocks to the exchange rate are found to be less important for exchange rate fluctuations than in many other structural macroeconomic models.