Monetary Policy and Exchange

Rate Pass-through: Theory and

Evidence
Michael B. Devereux and James
Yetman
Main Features:
The paper develop a model of exchange rate pass-
through based on the frequency of price changes
by importing firms;
The price change frequency is influenced by the
monetary policy rule.
looser monetary policy rule lead to high mean
inflation and high volatility of the exchange rate.
Prediction: there should be positive relationship
between pass through and mean inflation and
between pass through and exchange rate volatility.
The Importing Firm:

If the firm can freely
adjust the price, then

*
1
) (
t t t t
P S i P u

=
.
A menu cost F
As in Calvo (1983)
there is a probability
that firms change prices
at any period. The
optimal price for the
newly price setting
firm is:
k 1
) ( ] )
1
)[ln( 1 ( ) (
1
~
*
~
i p E p s i p
t t t t t t +
+ + + +

= |k u

|k
(1)
Price index for imported goods
1
~
) 1 (

+ =
t t t
p p p
(2)
Determination of the exchange rate
Equations (1) and (2)
determine the degree of
pass-through from
exchange rates to prices.
The monetary rule:




The home consumer Euler
conditions:
1 , 1
1
) (
>
|
|
.
|

\
|
= +

o
o
v
t
t
t
P
P
e i
t
o
o
o
o
|
|
1 1
1 1
1
*
1
1
1
1
+ +
+ +
+
=
+
=
+
t t
t t
t
t
t t t
t t t
t
t
C P
C P
E
i
S C P
S C P
E
i
(3)
(4)
(5)
Inflation and real exchange rate
determination
The combination of the interest rule , (5),
the Euler equations, (3) and (4), and foreign
firm pricing equations, (1) and (2),
determine inflation and real exchange rate
determination.
Inflation equation for imported
goods prices
Combining (1) and (2)
yields the imported
price inflation:


(6)
t t t t t
E q + + + =
.
) (
Log Linearization
Approximation of the Euler
conditions yields:
Interest Parity

Interest rule---

Combining the two
relationships yields
A relationship in real
exchange rate and
inflation--- (7)
1 1
*
1
*
+ +
+
+ + + = +
+ + =
+ =
t t t t t t t t
t t t
t t t t t
E q q E r
i
s s E i i
t | u ot
u ot |
Equations (6) and (7) give a simple
dynamic system in domestic
inflation and the real exchange rate
With autoregressive
stochastic processes
these equations are
solved:
t t t t
t t t t
b b r b q
a a r a
u u
o q
| |
u u
o
|
t
3 2
*
1
3 2
*
1
) 1 (
) 1 (
) 1 (
+ + +

=
+ + +

=
.
Intuition
If the monetary authority
has a target for
nominal interest rate
which is smaller than
the foreign interest
rate,
, then the steady state
inflation is positive,
and relatively high real
exchange rate.
0 < |
The higher is the coefficient
on inflation in the
monetary rule, the smaller
are both mean inflation
and steady state
depreciation in the real
exchange rate. Hence for
a given parameter
tighter monetary policy (
high ) implies a
lower mean inflation.
|
o
Exchange Rate Pass-Through
From equation (6) DY
write the equations
for the domestic price
level, and nominal
exchange rate:




1 1 1 3 1 2
*
1 1 3 3 2 2
*
1 1
*
1 3 2
*
1
) ( ) ( ) (
1
1

+ + + + + + + +

+ =
+ + + +

=
t t t t t t t t t
t t t t t
p s b b r b a b a b r a b p s
p a a r a p
t
u u u u
o
|
u u
o
|
Real foreign interest rate shocks
Focusing on the effect of real
foreign interest shocks, or
equivalently, domestic
monetary shocks, DY
demonstrate that the exchange
rate responds by more than the
domestic price levels, since
such shocks cause both
immediate real depreciation as
well as domestic inflation.
For a given value of
Monetary policy has no effect on
pass through.
k
Endogenous Price Rigidity
With menu costs, the
higher is inflation, the
more costly it is for a firm
to set its price in terms of
domestic currency, and
have the profits eroded by
exchange rate
depreciation. DY postulate
the following choice
problem for
]} )) ( ) ( ( ) ( [
1
1
min{ min
2
~ ~
0
1
i p i p E F L
j t t
j
j
t t +

+
|
|
.
|

\
|

=

|k
|
|k
Depends on the monetary rule. The
main finding is that the exchange
rate pass through also depends on
the monetary rule!
Critique
Output is treated as an exogenous variable.
Thus, the output gap does not play a role in
the pass through from the exchange rate to
domestic prices.

An extension will produce a new Keynesian
aggregate supply relationship, as in
Loungani, Razin and Yuen:
Open-Economy New-Keynesian
Phillips Curve
|
|
.
|

\
|

+
|
|
.
|

\
|

+
+
=
= = +

. . . .

.
.
) log( ) log( )
1
1
( )
1
(
) )(
1
) 1 (
( ) )(
1
( )
1
( ) (
0 *) 1 (
1
1
t t t
N
t
F
t
N
t
H
t
t t t
N
t
e E e
n
n
Y Y
n
Y Y
n
E
C C r
t

ue
=
ue
e

t t
|

di i di i h i w B i f B i M
B B M
i
i
di i c i p di i c i p
di i p di i p P
di i c di i c C
di i h v P M C u E
n
t
n
t t t t t t t t t
t t t t
t
t
n
t t t
n
t t
n
t t
n
t t
n
t
n
t t
n
t t
t
t t t t
t
} }
} }
} }
} }
}

[ + + + + + + =
+ +
|
|
.
|

\
|
+
+ +
(

+ =
|
|
.
|

\
|
(

+
(

=
0 0
*
1
*
1 , 1 1 1 1
*
1
* *
0
1
1
1
1 *
0
1
1
1 1
*
0
1
0
0
0
) ( ) ( ) ( ) 1 ( ) 1 (
1
) ( ) ( ) ( ) (
) ( ) (
) ( ) (
] ) ); ( ( ) ; / , ( [
c c
c
|
u
u u
u
u
u
u
u
u
(
(

(
(

=
[ + =
+
H + + + +
+ = + +
|
|
.
|

\
|
+
+ +

}
} }
}
}
} }

0
0
0 0
0 0
0
0
*
1
*
1 , 1 1 1
1
*
1
* *
0
) ); ( ( ) ; ; (
) ( ) ( ) (
) ( ) (
) ( ) 1 ( ) 1 (
1
) ( ) ( ) ( ) (
t
n
t t t
t
t
t
t
n
t
n
t t t t
n
t t
n
t t t t t t t
t t t t t
t
t
n
t t t
n
t t
di i h v
P
M
C u E U
di i di i h i w y P
di i h i w
di i B i f B i
M B B M
i
i
di i c i p di i c i p
|
c
c
t
t
t t t c
t t h
t t t c
t t t c
t
t
t t t c
t t t m
t
t t
t t
P
i w
m c u
i h v
r
m c u
m c u
i
i
m c u
m c u
f
i i
) (
) ; ; (
) ); ( (
*) 1 (
) ; ; (
) ; ; (
1 ) ; ; (
) ; ; (
) 1 ( 1
1 1 1
1 ,
*
=
+ =
+
=
|
|
.
|

\
|
+ = +
+ + +
+

c
)) ( ( ) (
) (
) (
j h f A j y
P
j p
C j c
t t t
t
t
t t
=
|
|
.
|

\
|
=
u
Firms Optimization:
)
) (
(
1
) ; / , (
) ; (
1
)
) (
(
) (
) (
))
) (
( ( '
1
)
) (
(
1
)
) (
( ) ( ) (
)
) (
( ) ( ) ( ) (
1
1
t
t
t t t t t c
t t h
t t
t
t
t
t
t
t
t
t
t t
t
t t
t
t
t t t
A
i y
A P M C u
h v
A A
i y
P
i w
i s mc
A
i y
f f
A
i y
A A
i y
i w i S MC
A
i y
f i w i h i w VC

= =
=
=
= =

Nominal
Real
t
t
t t t t
t
t
n
P
i y i p F
t
n
P
i y i p H
t
F
t
H
t
W
t
t
t W
t
d
t
t c
h
t
t t t t t
t
t
p
p
A C y s
P
p
di Y
di Y
Y Y Y
P
i p
Y y
A y f Af C u
A y f v
A C y s
A j y f f A P
j w
j s
t
t t t
t
t t
2
1
1
1
1
) ( ) (
0
) ( ) (
1
1
~
1
1
1
1
) , ; , (
)
) (
(
)) ; / ( ( ' ) ; (
)) ; / ( (
) , ; , (
)) ; / ) ( ( ( '
) (
) (
* *

>

=
=
=
=
+ =
=
=
=
}
}

u
u

c
u
Flexible prices
Set price one period in advance
ONE-PERIOD NOMINAL RIDIGITY
|
| 0 )] ; ; ( [ ) ; (
0 )] , ; , ( (
1
1
0
) (
) (
1
1
)] ( ) ( [
1
1
] [
1
1
) (
1
1
~
1
1
2
2
1
1
2
1
1
1
2
1 1
2
1
1
2 2
1
1
1
1
=
=

+
=
c
[
+
c

+
=

+
= [
+

t t t t t t c t
t t t t
t
t
t
W
t
t
t
t
t
t
t
t
t t
W
t
t t t
W
t
t
t
t t t t
t
t
t
t
t
y y s y y u E
A C y s
P
p
P Y
i
E
i p
i
i
E
A
p P Y
f w i p P Y
i
MaxE
h w y p
i
MaxE
i
i
MaxE


u
u
u
u u
) , ; , ( 1
1
) , ; , (
) 1 (
) , ; , (
) 1 (
1
) 1 ( ] ) 1 ( [
) 1 /( 1 ) 1 ( * 1
) 1 /( 1 ) 1 ( * 1
1
1
) 1 ( * 1
2
1
1
] [
] [
t t
N
t
N
t
t t
N
t
N
t
t
t
t
t
N
t
N
t
t t
N
t
N
t
t
t
t
t
t
t
t t
t
A Y Y s
n
A Y Y s
p n np
p
Y C
A C Y s
p n np
p
p n p p n P


c

c

c
u u u
u u u
u
u u u
=
=
=
+
=
=
+
=
|
.
|

\
|
+ + =

.

~ =
= = = = =
= +
x
x x
x
x
x
C C p p A A o
r
t t
t
t t t t t
) log(
. , , , ,
1 *) 1 (
*
*
c c
|
Steady state:
The Phillips Curve
c
cc
p
h
hh
w
p w
N
t t
N
t
t
N
t t
u
y u
f f f
A
y
f f
f v
A
y
v
C C Y y s s
=
= =
+ =
+ =

. .

. . . .
o
e e
e e e
o e
(.) (.)) ( '
) (.))( ( ' '
,
'
) (
) ( ) (
1
1
1
where
y
A
y
y
A
y
A
A
y
f v
y
A
y
A
y
f v
A
y
f f
A
y
C C u
C u
h
hh
cc
c
) (
) ( '
) ); ( (
) ( ) ); ( (
)) ( ( '
1
) ( ,
) ; (
) ; (
1
1
1

o
+ =
=

Elasticity of wage demands,

wrt to output, holding
marginal utility of income
constant
Elasticity of marginal product of
labor wrt output
Log-linearization of real mc:
n
t t t
t
t
t ss
t i
t
t
t t ss
t i
t
t
t t ss
t i
ss i i
t t
t t c
t
t
t
t
t
h
t t t
y y i y i s
A A
A
F
s
y
y
y y
y
F
s
i y
i y
i y i y
i y
F
s
s s
i y F
y u
A
i y
A
i y
v
y y s
.

. .
+ + =

c
c
+
c
c
+
c
c
+ =
=
) ( ) ( ) (
) (
1
) ) (
1
) (
) (
) ) ( ) ( (
) (
1
) log( ) log(
) ); ( (
) ; (
)
) (
( ) ;
) (
(
) ; ; (
1 1
_
_
_
_
o e o e

Partial-equilibrium relationship?
|
|
.
|

\
|

+
|
|
.
|

\
|

+
+
+

+
+
=
= =
+ + =
+ + =
+ + =

. .

. . . .

. .

. .

. .

. .
) log( ) log( )
1
1
( )
1
(
) )(
1
( ) )(
1
) 1 (
( ) )(
1
( )
1
( ) (
), log( ) log( ) ( ), log(
) log( ) 1 ( )] log( ) 1 ( ) log( [ ) log(
)] ( ) ( ) [log( ) log(
) ( ) ( ) log( ) log(
1
1
1
*
1 1
1
*
2 1
1
2 1 2
1
1 1
t t t
N
t
F
t
N
t
F
t
N
t
H
t
t t t
t
t
t t t t t t t t
t
t
t
t t t t t
N
t
t
N
t
t t t t
N
t
t
N
t
t t t
e E e
n
n
C C Y Y
n
Y Y
n
E
P
P
e P E P E
P
P
p n p p n P
C C Y y P E p
C C Y y P p

ue
o
ue
e
ue
e

t t
c t t t
c
o e
o e
|
|
.
|

\
|

+
|
|
.
|

\
|

+
+
+

+
+
=
= =
|
|
.
|

\
|

+
(

+
+
+
(

|
|
.
|

\
|

+
(

=

(

=
+ =
+ =
+ + =
=

+
+
+
+ =

+
+
+
+ =
=
=
+ + =
+ + =

. .

. . . .

. .

. .

. .

. .

. .

. .
. . .
. .
. .

. .

. .

. .
) log( ) log( )
1
1
( )
1
(
) )(
1
( ) )(
1
) 1 (
( ) )(
1
( )
1
( ) (
), log( ) log( ) ( ), log(
)] [log( ) log( )
1
1
(
1
) (
1
1
) (
1 1
) log( ) log(
)] [log( ) log( )
1
1
(
1
)] log( ) [log(
1
) log( ) log(
)] log( ) 1 ( ) log( ) [log(
) 1 (
1
) log(
)] log( ) )[log( 1 ( )] log( ) log( [
)] log( ) )[log( 1 ( )] log( ) log( [ ) log( ) log(
) log( ) 1 ( )] log( ) 1 ( ) log( [ ) log(
) log( ) log(
)] (
1
1
) (
1
) [log( ) log(
) (
1
1
) (
1
) log( ) log(
) 1 (
)] log( ) [log(
)] ( ) ( ) [log( ) log(
) ( ) ( ) log( ) log(
1
1
1
1 1
1
1
1
1
*
1 1 1
*
1 2
*
1
*
2 1
*
1
*
1 1 1 1
*
2 1
1 1 2
1
1 2
1
1
1
2 1 2
1
1 1
t t t
N
t
F
t
N
t
F
t
N
t
H
t
t t t
t t t t t t
t
t
t
t t t
N
t
t
N
t
W
t
t t t
t
t
t t
t t t t t t t t
t t t t t
t t t t t t t
t t t t t t t t t t t
t t t t t
t t t
N
t
t
N
t
W
t
t t t
N
t
t
N
t
W
t
t t
F
t
H
t
W
t
t jt
W
t
jt
N
t
t
N
t
t t t t
N
t
t
N
t
t t t
e E e
n
n
C C Y Y
n
Y Y
n
E
P E P E
P
P
e E e
n
n
C C Y Y P E P
P
P
e
e E e
n
n
P p P E P
p n p n P
n
p
p E p n p p n
p E p n p E p n P E P
p n p p n P
p E p
C C Y Y P E p
C C Y Y P p
Y n Y n Y
P p Y y
C C Y y P E p
C C Y y P p

ue
o
ue
e
ue
e

t t
t t t
ue
o
ue
e

c c
c c
c
ue
o
ue
e
ue
o
ue
e
u
o e
o e
Closing the capital account:
|
|
.
|

\
|

+
|
|
.
|

\
|

+
+
+

=
= =

. .

. .

. . . .
) log( ) log( )
1
1
( )
1
(
) )(
1
) 1 (
( ) )(
1
( )
1
( ) (
,
1
1 1
1
t t t
N
t
F
t
N
t
H
t
t t t
N
t
N
t
H
t t
e E e
n
n
Y Y
n
Y Y
n
E
Y C Y C

ue
o
ue
o e

t t
Closing the trade account:
|
|
.
|

\
|

+
+

=
=
. .

) )(
1
( )
1
( ) (
1
1
1
N
t
H
t
t t t
Y Y E
n
ue
o e

t t
Sacrifice Ratios in Closed vs.
Open Economies: An Empirical
Test
Prakash Loungani, Assaf Razin, and
Chi-Wa Yuen
Background
Lucas (1973) proposed a model in which the effect arises
because agents in the economy are unable to distinguish
perfectly between aggregate and idiosyncratic shocks; he
tested this model at the aggregate level by showing that the
Phillips curve is steeper in countries with more variable
aggregate demand. Ball, Mankiw and Romer (1988) showed
that sticky price Keynesian models predict that the Phillips
curve should be steeper in countries with higher average
rates of inflation and that this prediction too receives
empirical support
The data used in the regressions reported in this paper are taken from
Ball (1993, 1994) and Quinn (1997).

Sacrifice ratios and their determinants: Our regressions focus on
explaining the determinants of sacrifice ratios as measured by Ball. He
starts out by identifying disinflations, episodes in which the trend
inflation rate fell substantially. Ball identifies 65 disinflation episodes
in 19
DATA
OECD countries over the period 1960 to 1987. For each of these
episodes he calculates the associated sacrifice ratio. The denominator
of the sacrifice ratio is the change in trend inflation over an episode.
The numerator is the sum of output losses, the deviations between
output and its trend (full employment) level.
Sacrifice ratios and their determinants: Our
regressions focus on explaining the
determinants of sacrifice ratios as measured
by Ball. He starts out by identifying
disinflations, episodes in which the trend
inflation rate fell substantially. Ball identifies
65 disinflation episodes in 19 OECD countries
over the period 1960 to 1987. For each of these
episodes he calculates the associated sacrifice
ratio. The denominator of the sacrifice ratio is
the change in trend inflation over an episode.
The numerator is the sum of output losses, the
deviations between output and its trend (full
employment) level.
For each disinflation episode identified by Ball, we use as an
independent variable the current account and capital account
restrictions that were in place the year before the start of the
episode. This at least makes the restrictions pre-determined with
respect to the sacrifice ratios, though of course not necessarily
exogenous.

Quinn (1997) takes the basic IMF
qualitative descriptions on the presence of
restrictions and translates them into a
quantitative measure of restrictions using
certain coding rules. This translation
provides a measure of the intensity of
restrictions on current account
transactions on a (0,8) scale and
restrictions on capital account
transactions on a (0,4) scale; in both cases,
a higher number indicates fewer
restrictions. We use the Quinn measures,
labeled CURRENT and CAPITAL,
respectively, as our measures of
restrictions.
Capital Flow Restrictions
Sacrifice ratios and Openness Restrictions
Independent variable
(1) (2) (3) (4)
Constant -0.001
(0.012)
-0.059
(0.025)
-0.033
(0.022)
-0.058
(0/026)
Initial inflation 0.002
(0.002)
0.003
(0.002)
0.003
(0.002)
0.003
(0.002)
Length of Disinflation 0.004
(0.001)
0.004
(0.001)
0.004
(0.001)
0.004
(0.001)
Change of inflation
during episode
-0.006
(0.003)
-0.007
(0.003)
-0.006
(0.003)
-0.007
(0.003)
CURRENT
0.008
(0.003)
CAPITAL
0.010
(0.006)
OPEN
0.006
(0.002)
Adjusted R-Square
0.16 0.23 0.19 0.23
Number of
observations
65 65 65 65
Numbers In parantheses are standard errors
Conclusion
In our earlier work we showed that restrictions of
capital account transactions were significant
determinants of the slope of the Phillips curve, as
measured in the studies of Lucas (1973), Ball-Mankiw-
Romer (1998), and others.
The findings of this note lend support to this line of
work, in particular to the open economy new
Keynesian Phillips curve developed in Razin and Yuen
(2001). We find that sacrifice ratios measured from
disinflation episodes depend on the degree on
restrictions on the current account and capital
account. Of course, to be more convincing this finding
will have to survive a battery of robustness checks,
such as sub-sample stability, inclusion of many other
possible determinants (such as central bank
independence) in the regressions, and using
instruments to allow for the possible endogeneity of
the measures of openness.