Transmission Mechanism of Exchange Rate Pass-through in India
| Author | Rucha R. Ranadive,L.G. Burange |
| DOI | 10.1177/0015732515598589 |
| Date | 01 November 2015 |
| Published date | 01 November 2015 |
| Subject Matter | Articles |
Transmission Mechanism
of Exchange Rate
Pass-through in India
Rucha R. Ranadive1
L.G. Burange2
Abstract
The degree of transmission of the exchange rate fluctuations to domestic
prices manoeuvres the monetary policy actions in order to contain the infla-
tionary pressure on the economy. The study intends to analyze the exchange
rate pass-through to import and domestic prices in India after the global finan-
cial crisis applying unrestricted VAR model and innovation accounting tools
such as impulse response functions and variance decomposition. The empirical
study has been undertaken from April 2009 to May 2013 considering eight vari-
able VAR consisting of oil prices, output gap, the exchange rate, interest rate,
money supply, import prices, wholesale prices and consumer prices in India.
Incomplete pass-through to import and domestic prices has been encountered
and the transmission of pass-through declines along the distribution chain of
pricing. The magnitude of pass-through is high for import prices and moderate
to wholesale and consumer prices. The variance decomposition results reveal
that industrial output, interest rate and money supply impact domestic prices
to a greater extent in India.
JEL: C32, F31
Keywords
Exchange rate pass-through, prices, VAR, impulse response function, variance
decomposition
Foreign Trade Review
50(4) 263–283
©2015 Indian Institute of
Foreign Trade
SAGE Publications
sagepub.in/home.nav
DOI: 10.1177/0015732515598589
http://ftr.sagepub.com
Corresponding author:
Rucha R. Ranadive, Department of Economics (Autonomous), University of Mumbai, Kalina, Santacruz
(East), Mumbai 400 098, India.
E-mail: rucha.ranadive@gmail.com
1 Research Scholar, Department of Economics (Autonomous), University of Mumbai, Kalina, Santacruz
(East), Mumbai, India.
2 Professor of International Economics, Department of Economics (Autonomous), University of
Mumbai, Kalina, Santacruz (East), Mumbai, India.
Article
264 Foreign Trade Review 50(4)
Introduction
The high level of inflation rate has always been a cause of concern for the devel-
oping countries including India. Therefore, policy makers are vigilant about the
economic indicators such as inflationary pressure in the economy. The extent to
which the exchange rate and import prices influence domestic inflation, known as
the exchange rate pass-through (henceforth, ERPT), is of a major concern for the
monetary policy.
The ERPT refers to the transmission of the exchange rate changes into
import prices of specific goods in the destination market currency (Saha &
Zhang, 2011). According to Goldberg and Knetter (1997), the textbook defini-
tion of ERPT is the percentage change in local currency in import prices result-
ing from 1 per cent change in the exchange rate between importing and
exporting countries. Broader definition of ERPT implies change in domestic
prices that can be attributed to change in the nominal exchange rate. ERPT is
complete if change in the exchange rate brings about a proportional change in
the domestic prices otherwise it is incomplete. Formally, the statistical rela-
tionship between the import prices to the exchange rate can be written as
follows:
Dpt = gDet + et (1)
where,
pt = natural log of import price
et = natural log of nominal exchange rate
et = error term.
The ERPT coefficient is g. If g = 1 then the ERPT is complete. However, if g < 1
then ERPT is partial or incomplete (Barhoumi, 2006). ERPT not only refers to
the effect of the exchange rate changes on import and export prices but also on
consumer prices, producer prices, investment and trade volumes (Tandrayen-
Ragoobur & Chicooree, 2013). The transmission mechanism of ERPT has two
stages. In the first-stage pass-through a depreciation of the exchange rate
increases prices of imported goods and in the second-stage pass-through,
increase in prices of imported goods, in turn, raises prices of domestically pro-
duced goods through supply and demand channels (Bhattacharya, Ila & Shah,
2008).
The objective of this study is to empirically examine the ERPT along the dis-
tribution chain of pricing in India after the eruption of the global financial crisis.
The analysis would be undertaken using the unrestricted VAR model and innova-
tion accounting tools.
The structure of the article is as follows, The second section overviews the
literature related to the ERPT. The data and model adopted for the analysis are
explained in the third section. The fourth section lists the empirical results,
which are presented in various subsections. The concluding remarks have been
given in the last section.
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