The Exchange Rate Passes Through To Inflation Economics Essay

The chief focal point of this paper is to analyze exchange rate base on balls through-to rising prices. Inflation is the addition in the general monetary value degree quoted in the units of is normally said as the one-year per centum growing of some wide index of money is besides said as the autumn in the buying power of pecuniary units

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Monetary values show a rapid alteration in about all states since the 1970s. Like most developing states, in Pakistan besides, the domestic monetary value degree started lifting from the mid-1970s.And the exchange rate started deprecating continuously from the early 1980s

The consequences, shows a low exchange rate pass-through to domestic monetary values, has an of import deduction for the pecuniary policy execution.


Macroeconomic indexs are used to exemplify the state ‘s economic status. One of the basic macroeconomic indexs is rising prices.


Inflation is the addition in the general monetary value degree quoted in the units of is normally said as the one-year per centum growing of some wide index of money is besides said as the autumn in the buying power of pecuniary units

Inflation rates vary from twelvemonth to twelvemonth and from currency to currency.economies sometimes experience rising prices on gold and Ag. rising prices rate is most normally measured by the per centum rise in the Consumer Price Index.

The chief cause of rising prices is the buying power of the dollar psychiatrists. That the nominal supply of dollar grows faster than the existent demand to keep dollar.

The prevailing position in conventional economic sciences is that rising prices is caused by the interaction of the supply of money with end product and involvement rates. Mainstream economic expert positions can be divided into two cantonments:

The “ monetarists ” who believe that pecuniary effects dominate all others in puting the rate of rising prices,

The “ Keynesians ” who believe that the interaction of money, involvement and end product dominate over other effects.

Other theories, such as those of the Austrian school of economic sciences, believe that an rising prices of overall monetary values is a consequence from an addition in the supply of money by cardinal banking governments.

Pakistan Inflation Rate:

The rising prices rate in Pakistan was recorded at 11.30 per centum in June of 2012. Historically, from 2003 until 2012, Pakistan Inflation Rate averaged 10.6400 Percent making an all clip high of 25.3300 Percentage in August of 2008 and a record depression of 1.4100 Percentage in July of 2003.

Inflation rate is the general rise in monetary values measured against a standard degree of buying power.

The most celebrated steps of Inflation are the CPI which measures consumer monetary values, and the GDP deflator, which measures rising prices in the sum of the domestic economic system. This is a chart with historical informations for Pakistan Inflation Rate.

Exchange rate:

“ Exchange rate is besides known as foreign exchange rate. It is the rate between two currencies ay which one currency will be exchanged for another ”

It is considered as the value of one state ‘s currency in footings of another currency

For illustration, an interbank exchange rate of 91 Sri lanka rupees to the United States dollar ( US $ ) means that Rs 91 will be exchanged for each US $ 1 or that US $ 1 will be exchanged for each Rs91. Exchange rates are determined in the foreign exchange market, which is unfastened to a broad scope of different types of purchasers and Sellerss where currency trading is uninterrupted. The topographic point exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for bringing and payment on a specific hereafter day of the month is expected.

Money traders will cite the different purchasing and selling rate in the retail currency exchange market. Most trades are to or from the local currency. Rate of purchasing is the rate at which money traders will purchase foreign currency. And the merchandising rate is the rate at which money traders will sell foreign currency.

Exchange rate base on ballss through to rising prices:

For mensurating the monetary value stableness in the economic system rising prices rate is used. Inflation comes from the domest fctors ( internal force per unit area ) and besides from the abroad factors ( external force per unit area ) . The beginnings of external factors are the addition in the universe trade good monetary values or exchange rate fluctuation. The influence of exchange rate towards rising prices itself depends on the pick of exchange rate government in the state. For cut downing or maximising the hazard of fluctuations in exchange rates the exchange rate system plays a really of import function. This impacts on the economic system every bit good. Any alterations in exchange rates will hold a great impact on the economic system.

Monetary values show a rapid alteration in about all states since the 1970s. Like most developing states, in Pakistan besides, the domestic monetary value degree started lifting from the mid-1970s.And the exchange rate started deprecating continuously from the early 1980s.Because of this Continuous devaluation of currency and rising prices in the 1980s seems to propose a correlativity between the two variables. Exchange rate provides a nexus between the domestic and universe markets for goods and assets. In the system of drifting exchange rates, exchange rate fluctuations can hold a strong impact on the degree of monetary values through the aggregative demand ( AD ) and aggregative supply ( AS ) .

The alterations in the exchange rate base on balls through consequence monetary values, It is an of import issue in arguments about appropriate pecuniary and exchange rate policies.

The hypothesis “ exchange rate alterations affect consumer monetary values ” is of import for policy-makers due to its relevancy to effectivity of pecuniary and exchange rate policies and acceptance of a more flexible exchange rate government. In the traditional literature, Exchange Rate Pass-through ( ERPT ) is defined in footings of import monetary values in local currency of the state.

Harmonizing to Goldberg and Knetter ( 1997 ) ,

“ Exchange rate pass-through is the per centum alteration in import monetary values in local currency ensuing from a one per centum alteration in the exchange rate between the exportation and importation states ”

Percentage alteration in domestic monetary values ensuing from one per centum alteration in exchange rate is defined as ERPT. Changes in exchange rate can impact domestic monetary values through indirect and direct channels. Under the direct channel, a autumn in exchange rate may trip increase in the monetary values of imported finished goods and imported inputs in local currency

Under the indirect channel when the exchange rate depreciates it makes the domestic merchandises comparatively cheaper or low cost for the foreign purchasers and as a consequence aggregative demand and exports rise and bring on an addition in the domestic monetary value degree. Since nominal pay contracts are fixed in the short tally, existent rewards decline. When existent rewards approach to their original degree over clip, the production cost additions and the overall monetary value degree moves up.

Literature reappraisal:

Recent literature tends to stress the importance of ERPT in carry oning effectual pecuniary and exchange rate policies. There are few surveies on ERPT for Pakistan. The present surveies provide assorted consequences sing the relation between exchange rate and monetary values ; nevertheless, the dominant position is that there is no cogent evidence of any important consequence of devaluation on domestic monetary value rising prices

Ahmad, Eatzaz ; Ali, Saima Ahmed ( September 22,1999 ) defines the synchronised function of rising prices and exchange rate in Pakistan by seeing impermanent and lasting dazes that how two variables are being adjusted and what is the form of two variables in rejoinder of these dazes. The dazes which they study are existent and pecuniary dazes and besides the import monetary values, export monetary values and foreign exchange militias. They find that the relationship between the monetary value degree and exchange rate is non unidirectional. Motions in the exchange rate occur largely due to alterations in the monetary value rising prices therefore exchange rate can non be used as independent instrument in the presence of rising prices. Hence, they conclude that both the rising prices and exchange rate are the interrelated with each other.

Siddiqui, Rehana ; Akhtar, Naeem ( December 22, 1999 ) done a instance survey of Pakistan in which they see the consequence of exchange rate on monetary values. They want to analyze the impact of alterations in the pecuniary and existent variables and alterations in foreign monetary values on domestic monetary values of a state. To look into the causality between alterations in the exchange rate and domestic monetary values they applied the unit root trial and mistake rectification mechanism. The consequences of all variables show non stationary. Besides they did n’t happen any unidirectional or bi directional relationship between the two variables but they find that the money supply and degree of activity effects domestic monetary values.

Peter Rowlan and Banco de la Republica ( 2001 ) analyze the exchange rate pass-through to domestic monetary values in the instance of Colombia. In their survey they use two changed attacks to see the exchange rate base on balls through to import, manufacturer and consumer monetary values. Johansen attack is used after unrestricted VAR theoretical account. The survey concludes that pass-through in Colombia is non complete. It is unassertive for manufacturer monetary values and really limited for consumer monetary values i.e. exchange rate daze had really little impact on consumer instance of Colombia domestic monetary values can be

calculated through exchange rate. Two different attacks to acquire the exchange rate base on balls through to import, manufacturer and consumer monetary value.

Ehsan U. Choudhri and Dalia S. Hakura ( December 2001 ) prove a hypothesis that low inflationary environment intimations to a low exchange rate pass-through to domestic monetary values. This paper derives the pass-through relationship centered on new unfastened economic system. Data of 71 states is used to see the relationship. And consequences showed the positive association between the base on balls through and mean rising prices across states. It is because that in state of affairs of high rising prices, pecuniary dazes are more regular and they reflect in exchange rate in high grade.

Jeannine Bailliu and Eiji Fujii ( June 2004 ) study the exchange rate pass-through and the rising prices environment in the industrialised states It is really much different from other surveies in the sense that it uses the panel informations attack. Panel information set of 11 industrialised states over the period from 1977 to 2001 is used to look into the hypothesis that exchange rate pass-through beads with transference to a low rising prices by a alteration in the pecuniary policy. Evidence wires this hypothesis. besides pass-through to import, manufacturer, and consumer monetary value rising prices declined in many industrialised states in the early 1990s for the rising prices stabilisation.

Zulfiqar Hyder and Sardar Shah ( June2004 ) have done paper on Exchange Rate Pass-Through to Domestic Prices in Pakistan. They say that the sweeping and domestic monetary values in Pakistan are the consequences of exchange rate motions. They analyze the information from January 1988 to

September 2003 by utilizing the recursive VAR theoretical account

Michele Ca ‘ Zorzi, Elke Hahn and Marcelo Sanchez ( March 2007 ) done a paper in which they study the exchange rate pass- through to monetary values in 12 emerging markets in Asia, Latin America and Central and Eastern Europe. Three vector autoregressive theoretical accounts are used in this. Result show that the ERPT in both import and consumer monetary values in really much higher in “ emerging ” markets than it is in the “ developed ” states. The paper besides finds strong grounds for a positive relationship between the grade of the ERPT and rising prices and this being of positive nexus has really weak empirical support.

Takatoshi Ito and Kiyotaka Sato ( May 2007 ) examined the pass-through consequence of currency devaluation on domestic monetary values in the crises affected countries of Latin America and East Asia. To analyze the rising prices presentation in the crises-affected states a structural VAR theoretical account is castoff to demo the CPI responses to assorted dazes. Consequences of their survey show that the grade of exchange rate pass-through is higher in Latin American states and Turkey than it is in East Asiatic states of the universe. This high exchange rate pass-through is one factor of the high rising prices rate in these states after crises.

Atif Ali Jaffri ( 2009 ) they investigates the exchange rate alterations on consumer monetary values in Pakistan for both short tally and long tally and discover that the exchange rate alterations has really small consequence on consumer monetary values in Pakistan. The consequence of foreign rising prices on domestic rising prices is positive and statistically important. This survey is for the period 1995M1 to 2009M3.

Ramiz ur Rehman ; Muhammad Ateeq ur Rehman ; Awais Raoof ( 2010 ) in their survey examines the relationship between the involvement rate, exchange rate and rising prices. a simple multiple arrested development theoretical account is utile to see the relationship of rising prices and involvement rate with exchange rate as rising prices and involvement rate are taken as independent and exchange rate is taken as dependent variable. a monthly based information is scrutinized for this intent for Pakistan and united Kingdom. The consequences of this survey redirect that there is a important positive relation between rising prices and exchange rate of UK and Pakistan but important negative relation of involvement rate and exchange rate of Pakistan and UK.

There is a considerable theoretical and empirical literature on the exchange rate pass-through to domestic manufacturer and consumer monetary values, some of which has been measured in Goldberg and Knetter ( 1997 ) . However, much of the literature has allocated with advanced economic systems.

Turgut Kisinbay, Seiichi Shimizu, Anna Nordstrom, Jorge Restrepo, Scott Roger, Mark R. Stone November, 2009 explores the function of exchange rates in emerging economic systems with inflation-targeting organisations, by stating that Inflation-targeting emerging economic systems by and large have less flexible exchange rate agreements and intercede more often in the foreign exchange market than their advanced economic system opposite numbers.

Steven Kamin August 1997 describes research, associating the response of rising prices to alterations in exchange rate fight, it implies that it may non be possible to achieve low rising prices and a high export fight at the same time.

Theoretical model:

Inflation as a cardinal index that provides of import penetration on the province of the economic system and the sound macroeconomic policies that govern it. A stable rising prices non merely gives a cherishing environment for economic growing, but besides improves the hapless and fixed income citizens who are the most incapacitated in the society. The Government wants to be careful about rising prices and therefore has taken assorted stairss to relief demand force per unit areas on the one manus and enhances supplies of indispensable trade goods on the other, The State Bank of Pakistan ( SBP ) has continuously tightened the pecuniary policy over the last three old ages to ease demand force per unit area and more so in the current financial twelvemonth, while to better supplies, the Government has relaxed its import government. The CPI is used as the chief step of monetary value alterations at the retail degree. It specifies the cost of buying a representative fixed basket of goods and services used up by private families. In Pakistan, CPI covers the retail monetary values of 374 points in 35 major metropoliss and reflects approximately the alterations in the cost of life of municipal countries.

The chief purpose of pecuniary policy in Pakistan is to stabilise the economic growing by stabilising the domestic and external value of money.. Therefore, the exchange rate pass-through to domestic consumer monetary values is an of import device in the procedure of pecuniary policy transmittal. Since Pakistan ‘s economic system has a important grade of openness to foreign trade, therefore any grasp or any depreciation of the exchange rate will non merely consequence in major alterations in the monetary values of imported finished goods but besides imported inputs that disturbs the cost of the finished goods and services. Specifically, exchange rate motions can impact domestic monetary values through direct and indirect channels.

Exchange rate motions can impact the domestic monetary values through alterations in the monetary value of imported finished goods and imported inputs in instance of direct channel

In general, when the value of currency depreciates it will ensue in higher import monetary values while lower import monetary values result from grasp in monetary value taker states like Pakistan. In instance of indirect consequence, the exchange rate depreciation affects the net exports which in bend affect the domestic monetary values through the fluctuation in aggregative demand, seting upward force per unit area on domestic monetary values.

However, the velocity and the extent of exchange rate pass-through depends on several factors such as market construction, pricing policies, general inflationary environment, engagement of non-tradable in the distribution of tradable portion of imports.

Model specification, Methodology and informations aggregation:

To analyze the pass-through of exchange rate to domestic monetary values, this paper utilizes a arrested development attack to see whether at that place exists any relationship between two variables or non. The theoretical account is based on two chief variables:

ERP: Exchange Rate Position.

Consumer price index: Consumer Price Index


In this survey the one-year information for the period 1986 to 2010 is used here for the analysis.

Datas beginnings

And the chief beginnings of informations are

“ Pakistan economic study.

And “ World Bank site ”

Regression methodological analysis:

During the process of planning and determination devising in any empirical analysis related to economic sciences, arrested development technique helps a batch as it tackles the job of unsure fortunes and helps to understand the nature of the relationship between underlying variables and in theoretical account edifice.

In this paper for arrested development analysis OLS Regression analysis is used because of its mathematical simpleness and its consequences are besides really simple and easy to understand.

Model Specification:

In this portion the specification of the appropriate theoretical account for the analysis is necessary.

in order to turn out that whether the exchange rate is traveling to impact the rising prices rate in long tally in the economic system we need to develop a peculiar theoretical account for it,

CPI = I?1 + I?2 ERP + Aµt


CPI = consumer monetary value index

ERP = Exchange rate

I?2 = incline coefficient

The variable of rising prices has been represented as a dependant variable, and the exchange rate has been described as independent variable act uponing the rising prices rate in a state.

Empirical consequences:

The empirical estimations presented below provide penetrations into the relationship between exchange rate pass- through to CPI in Pakistan. They are estimated to see that if there exists a long tally relation in two variables because of which 1 may do another variable or non. Now the empirical consequences of empirical analysis are discussed below.

Relationship between Two Variables by utilizing arrested development attack

Using the informations of two variables, we regress CPI on ERP and obtain the undermentioned arrested development consequences.

CPI = 0.072078 + 1.095623 ERP

T = ( 0.575315 ) ( 32.20897 )

R2 = 0.978310

Consequences and Discussion:

CPI/ ERP arrested development consequences

Table 1
















*Indicates that coefficient is important at 0.10 chance degree.

** indicates that coefficient is important at 0.05 chance degree.

*** indicates that coefficient is important at 0.01 chance degree

R2 = 0.97

Adjusted R2 = 0.97

Table 1 shows the consequence of arrested development CPI/ERP ( income ) . It explains that ERP is positively related to CPI in Pakistan.

The estimated coefficient of ERP is 1.09 which is extremely statistically important at 0.01 chance degree. This shows that CPI additions by 1.09 % due to 1 % addition in ERP. So above mentioned consequences reveals that a positive and important relationship exists between CPI and ERP. Here r2 =0.97 which shows that about 97 % of the fluctuation in the CPI is explained by ERP. So this arrested development line fits the informations really good.


In this paper, we use a arrested development theoretical account on one-year informations from 1985 to 2010 for Pakistan. The findings of the paper suggest that:

The exchange rate motions have a important consequence on domestic monetary value rising prices particularly in instance of CPI.

consequences show that there is the impact of pass-through on domestic monetary values



Therefore, this consequence, which shows a low exchange rate pass-through to domestic monetary values, has an of import deduction for the pecuniary policy execution. Low exchange rate pass-through provides greater freedom for prosecuting independent pecuniary policy particularly through rising prices aiming government.


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The following tabular array contains the informations related to the exchange rate and consumer monetary value index of Pakistan from the twelvemonth 1985-1986 to 2009-2010.

Old ages


Consumer price index













































































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