Exchange Rate Pass-through to Domestic Prices

DOI10.1177/0015732516650828
Publication Date01 Aug 2017
AuthorGanapati Mendali,Sanjukta Das
SubjectArticles
Exchange Rate
Pass-through to
Domestic Prices:
The Indian Experience
Ganapati Mendali1
Sanjukta Das1
Abstract
This study makes an attempt to examine the exchange rate pass-through (ERPT)
to domestic prices in the post-reform period in India. It also analyzes the effect
of global financial crisis of 2007 on the ERPT. It has used the standard vector
auto-regression (VAR) model taking five variables (viz., exchange rate, oil price,
output gap, money supply and wholesale price index (WPI)) for analysis. Using
impulse response function, the study finds that a 10 per cent depreciation in
rupee (`) results in 0.011 per cent rise in WPI after one month. It found moderate
ERPT estimates ranging from 0.01112 per cent (after first month) to 0.01197
per cent (after six months). The cumulative pass-through is found to be 0.07 for
one month, it is stabilized at 0.06. The main drivers of price change are identified
through variance decomposition. Persistently rising WPI and the oil price hike
are found as the main drivers of price rise. Pressure of exchange rate on the WPI
is found to be very modest, that is, about 7 per cent. Using the Quandt-Andrews
Unknown Breakpoint test, the study found a structural break at November 2007,
but the effect of the crisis on ERPT is found to be insignificant. The study explains
the low ERPT in terms of India’s large import size and its composition in favour
of raw materials and intermediary goods, exchange rate volatility and moderate
inflation. It reduces the apprehension of domestic price instability arising from
the floating exchange rate.
JEL: E31, E37, F31
Keywords
Depreciation, exchange rate pass-through, WPI, VAR, India
Foreign Trade Review
52(3) 135–156
©2017 Indian Institute of
Foreign Trade
SAGE Publications
sagepub.in/home.nav
DOI: 10.1177/0015732516650828
http://ftr.sagepub.com
Article
1 P.G. Department of Economics, Sambalpur University, Jyoti Vihar, Burla, Sambalpur, Odisha, India.
Corresponding author:
Ganapati Mendali, P.G. Department of Economics, Sambalpur University, Jyoti Vihar, Burla, Sambalpur,
Odisha, 768019, India.
E-mail: ganapati14@gmail.com
136 Foreign Trade Review 52(3)
Introduction
Collapse of the Brettonwood system resulting in the transition from a fixed to a
floating exchange rate regime, has caused exchange rate volatility (ERV) in most
countries (De Grauwe, 1988). To avoid the volatility and its consequences on the
economy, a number of countries (both developed and developing) adopted some
form of exchange rate pegging like system of pegging to a single currency, joint
floating system, basket of currency approach etc. India having long association
with the UK had pegged its rupee (`) to pound (£). Then from 1975 to 1992 it
tagged its currency to a basket (consisting of the currencies of its major trade
partners) to avoid the consequences of floating rate on its trade and balance of
payments (BoP). Adoption of the new economic policy in 1991 and the introduction
of a series of economic reforms subsequently brought a number of changes in the
economy. Shifting to the floating (independent but managed floating) exchange
rate system (of course initially with some experiments) since 1992 has caused a
lot of apprehensions about the consequences of flexible rate on the trade, BoP,
output, domestic prices so on and so forth. Some efforts were made to examine the
likely effects of exchange rate changes on the trade balance taking the prices and
quantities of export and import, competitiveness of Indian exports etc. Effects of
exchange rate change on prices of import, export and domestic goods are measured
through exchange rate pass-through (ERPT), which may be defined as proportionate
change in prices to the proportionate change in exchange rate.
Patra and Pattanaik (1994) using the annual data from 1970–1971 to 1992–1993
tried to show that the floating exchange rate is likely to improve the trade balance of
India through its effect on export and import prices. It estimated ERPT to export
price at 0.93, almost a complete pass-through.1 Contrary to this, Ranjan (1995) tak-
ing almost the same period of analysis finds export price elasticity to exchange rate
change is too low to bring substantial improvement in export quantity and the earning.
Dholakia and Saradhi (2000), taking the quarterly data of Indian imports and exports
from 1980 to 1996, examined the impact of exchange rate volatility (ERV) on Indian
trade (and trade deficit). It estimated the ERPTs to import price as 0.823 and to
export price as 0.703. For the post-1991 period, the study also found almost complete
ERPTs in case of import price and very marginal decline in the ERPT to the export
price indicating the continuation of the price taking behaviour of the Indian firms.
Using the inter-industry panel data (from 1980 to 2001), Mallick and Marques (2006,
2008) found high but incomplete pass-through when data of all industries are consid-
ered as a whole. It also found that in the post-reform (1991–2001) period more number
of industries with incomplete pass-through compared to that in the pre-reform period
indicating a rise in the power and autonomy of the firms in the post-reform period.
Attempts are also found examining the ERPT to domestic prices. Ghosh and
Rajan (2007) estimated ERPT to India’s consumer price index (CPI) taking `–$
exchange rate and the nominal effective exchange rate (NEER). It found negligible
ERPT in case of NEER but relatively high ERPT in case of the bilateral exchange
rate. It also found higher ERPT (50 per cent) in the post-liberalization (1991–
2005) period compared to that in the pre-liberalization (i.e., 1980–1990) period
(38 per cent) which was attributed to the liberalization policy of the government.
Similarly, Khundrakpam (2008) using a recursive vector auto-regression (VAR)

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