Does the Exchange Rate Volatility Matter for the Reaction of Consumer Price Inflation to Exchange Rate Depreciation Shock

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.