Transmission of Inflation and Exchange Rate Effects: The Markov Switching Vector Autoregressive Methodology

Abstract

The aim of this study is to delve into the intricate the mechanism through which alterations in currency exchange rates give rise to shifts in inflation rates, while taking into careful consideration the country’s economic cycle. In order to accomplish this objective, we used a dataset that spanned from 1 January 1999 to 1 July 2023, focusing our analytical lens on three specific geographic areas, namely the Eurozone, the United Kingdom, and Canada. In our pursuit of understanding this complex relationship, we employed the Markov Switching Vector Autoregressive model. Our research outcomes can be succinctly encapsulated as follows: in the initial stages, particularly during phases characterized by robust economic growth, the transmission of exchange rate effects onto inflation levels appeared to exhibit a partial impact across all geographic areas under examination. However, during periods marked by economic downturns, both the United Kingdom and Canada displayed a distinctly more comprehensive transmission of these effects. Moreover, the prevailing projections for the forthcoming time horizon, across all the countries encompassed by our study, strongly indicate the onset of an expansionary phase that is projected to extend over a span of 25 months. Lastly, concerning the implications of unexpected disturbances or shocks, it is noteworthy that the response of exchange rates to inflation induced shocks was neither immediate nor as pronounced as the corresponding reaction of inflation to sudden shifts in exchange rates.