Academic journal article International Advances in Economic Research

Is There a Link between Exchange Rate Pass-Through and the Monetary Regime: Evidence from Sub-Saharan Africa and Latin America

Academic journal article International Advances in Economic Research

Is There a Link between Exchange Rate Pass-Through and the Monetary Regime: Evidence from Sub-Saharan Africa and Latin America

Article excerpt

Abstract This paper investigates the relationship between the monetary regime: pegged, currency board, dollarization, and the exchange rate pass-through for a sample consisting of 15 Sub-Saharan Africa countries and 12 Latin American countries. The research findings about pass-through rates will shed light on the feasibility of a monetary union for Sub-Saharan Africa. The inclusion of the latter country group was deemed desirable to explore pass-through behavior in several monetary regime options not often used in Sub-Saharan Africa.

Keywords Dollarization * Exchange rate pass through * Monetary union

JEL E00 * F00 * F30

Introduction

The choice of an exchange rate regime for developing and emerging countries is an ongoing debate in international finance. The general view held today is that intermediate exchange rate regimes are no longer viable, and that developing and emerging countries have to adopt either an extremely fixed or a fully flexible exchange rate regime. In an attempt to gain policy credibility, many countries have opted for extremely fixed regimes such as a currency board, monetary union, or official dollarization.

Although economists have extensively discussed the costs and benefits of fixed and flexible exchange rate regimes, an opportunity to further explore the economic implications of these regimes is presented in the exchange rate pass-through literature. Typically, the exchange rate pass-through is defined as the percentage change in local currency import prices resulting from a 1% change in the exchange rate between the importing and exporting countries. When import prices respond 100% to exchange rate movements, pass-through is said to be full or complete. On the other hand, a less than 100% response of prices means that pass-through is incomplete or partial. In this paper, the definition of exchange rate pass-through is broadened to include the impact of exchange rate movements on both import prices and consumer prices. Using this definition, I explore the link between exchange rate pass-through and the monetary regime in a sample consisting of 15 Sub Saharan African and 12 Latin American countries. The paper is organized as follows. Section "A Brief Overview of the Literature" provides a brief review of the pass through literature. Section "The Choice of the Monetary Regime" describes the monetary regimes in Sub Saharan Africa and Latin America. The empirical analysis and results are given in sections "Exchange Rate Pass-Through: Empirical Analysis" and "Results" respectively. The final section concludes.

A Brief Overview of the Literature

The Law of One Price (LOOP) stipulates that exchange rate pass-through into import prices should be complete. According to LOOP, and under the assumption of costless arbitrage, identical products would sell for the same common currency price in different countries. This relation is depicted by Eq. 1. In the equation, p is the home currency price of the good in country H, p* is the foreign currency price of the good in country F, and E is the exchange rate of H's currency per unit of F's currency. Thus for the good i:

[p.sub.i] = E[p*.sub.i] (1)

Empirical tests of the validity of LOOP for a good (i) over a given period of time (t), usually involves estimating the following regression--where all variables are expressed in logs:

[p.sub.t] = [alpha] + [delta]p* + [gamma][E.sub.t] + [[epsilon].sub.t] (2)

If LOOP holds, then Eq. 2 would predict that [alpha] = 0, [delta] = 1 and [gamma] = 1. Changes in the exchange rate would be completely passed through to the domestic price of good i.

The degree of exchange rate pass through is estimated using an equation similar to that given in (3),

[p.sub.t] = [alpha] [delta][X.sub.t] + [gamma][E.sub.t] + [psi][Z.sub.t] + [[epsilon].sub.t] (3)

where (all variables are in logs) p is the local currency import price, X is a measure of the exporter's costs, E is the exchange rate (expressed as the importer's currency per unit of the exporter's currency), Z is a set of control variables that may include import demand shifters such as competing prices or income, and [epsilon] is the error term. …

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