Abstract
Evidence based on the counterfactual analysis indicates the actual inflation rate rises less than what it would be if exchange rate volatility is allowed to transmit exchange rate depreciation shocks. In addition, the positive exchange rate volatility shocks directly reduce the size of the ERPT to inflation. The decline is much bigger to a persistent increase in the exchange rate volatility. This suggests that elevated exchange rate volatilities dampen the increases in consumer price inflation following an exchange rate depreciation shock. This happens through exchange rate volatility depressing output gap, economic growth, household consumption growth, exports growth and gross fixed capital formation. This evidence reveals that exchange rate volatility may be partly responsible for the lower ERPT to consumer price inflation post 2008 and it is another explanation for the prolonged negative output gap. These effects should considered in projections of policy rate path to minimise upward biases in expected policy rate.
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Notes
- 1.
Frankel et al. (2005) finds that the exchange rate variability has a positive effect on the speed of adjustment which is opposite from the Krugman-Froot-Klemperer-Taylor prediction.
- 2.
Wei and Parsley (1995) show evidence indicating that the postulation that holds at both sectoral and product levels.
- 3.
This may be suggestive that when firms expect the exchange rate or import price shocks to be persistent, they are more likely to change prices instead of adjusting profit margins (McCarthy 2007). This adjustment raises the size of exchange rate pass-through.
- 4.
However, Bloom (2009) argues that these models predict that high uncertainty should be followed by a quick bust boom cycle. Evidence in Bloom (2009), based on using exogenous shocks to changes in volatility indicated the postponement of irreversible investment. This postponement leads to a fall in the current level of economic activity.
- 5.
This theory outlines conditions under which the growth-enhancing effects of the exchange rate volatility are possible. This includes investment being reversible, firms operating in perfectly competitive markets, firms having long time spans. All these conditions may lead uncertainty shocks to enhance investment activity. Lelland (1968) and Kimball (1990) who showed that under certain assumptions, the role of households in dealing with uncertainty shocks.
- 6.
The negative effects arise when exporters are unable to diversify the exchange rate risk or see hedging as expensive as well as being impossible, which leads to a contraction in risk-adjusted expected profits from foreign trade (Arize 1996).
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Ndou, E., Gumata, N., Tshuma, M.M. (2019). Does the Exchange Rate Volatility Matter for the Reaction of Consumer Price Inflation to Exchange Rate Depreciation Shock?. In: Exchange Rate, Second Round Effects and Inflation Processes. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-13932-2_15
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DOI: https://doi.org/10.1007/978-3-030-13932-2_15
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