Page 18 - Azerbaijan State University of Economics

Vugar Rahimov, Nigar Jafarova: The Exchange Rate Pass-Through to Aggregate
Consumer Price Index and Its Components In Azerbaijan

1. INTRODUCTION
In most open and developing economies, the exchange rate exerts a significant
influence on inflation dynamics. Azerbaijan is not exception in this regard. Due to
the recent decline in oil prices starting from late 2014, the exchange rate of local
currency turned out to be extremely volatile. The Central Bank of Azerbaijan has
devalued the Azerbaijani Manat (AZN) and as a result, USD appreciated by 34
percent against AZN in February 2015. Later in December 2015, the Central Bank
switched to a managed float regime. Following the adoption of a new ER regime,
the USD has further appreciated by 47 percent. Since floating regimes enable the
exchange rate to act as a short-term macroeconomic adjustment mechanism, the role
of the ERPT becomes crucial in determining the potential contribution of higher
exchange rate volatility on the economy (Obstfeld and Rogoff, 1995; Rincon and
Rodriguez, 2016). On the other hand, the precise determination of the ERPT is a key
asset for central banks in monetary policy formulation process. Specifically, the
estimation of the ERPT to CPI components, i.e., food, non-food and service prices
are of great importance for obtaining better inflation forecasting output and for
adoption of adequate and timely monetary decisions.

Two main channels are differentiated in the exchange rate pass-through to domestic
inflation: direct and indirect channels. A direct channel operates through the cost
and consumption sub-channels. To put it in another way, via the cost channel, the
exchange rate shocks are first transmitted to the price of imported intermediate
goods, then to the producer prices and ultimately, to the final price of domestic
products. Through the consumption channel, the price of imported final goods and
services changes after the exchange rate shocks hit the economy, in turn, directly
influencing the overall price level in the country. Depending on the direction of
exchange rate movements, depreciation leads to more expensive imported final
products or vice versa. Consequently, through the direct channel, the ultimate
change in overall CPI basket will depend on the import substitutability, price
rigidities and the degree of competition in the market. In the case of an indirect
channel, depreciation of local currency initially results in higher exports, which
boosts output and hence, domestic inflation goes up. In the long run, when the
internal and external demand for local products goes up due to cheap exports, then
real wages are adjusted upwardly and subsequently, the cost of production and
hence, the price level increases and output shrinks (Kahn, 1987; Rincon and
Rodriguez, 2016). Additionally, Lafleche (1996, 1997) states that after depreciation,
expensive imports increase the internal demand and external demand for domestic
products through the expenditure switching effect.

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