Page 23 - Azerbaijan State University of Economics

THE JOURNAL OF ECONOMIC SCIENCES: THEORY AND PRACTICE, V.78, # 2, 2021, pp. 17-42

When it comes to the determinants of exchange rate pass-through, most of the
studies rely on both microeconomic and macroeconomic factors. If in 1980s the
incomplete ERPT was mostly explained by microeconomic principles such as mark-
up pricing and market competition, in 1990s macroeconomic foundations were stood
at the heart of much of the research to define the rise and development of the
exchange rate transmission mechanism. Referring to microeconomic foundations, in
most cases the ERPT is incomplete due to competition among firms and tendency to
adjust their mark ups (Dornbusch 1987). In other words, to a certain extent the
exchange rate shocks are absorbed by lowering firms’ profits and mark-ups (Campa
and Goldberg, 2002). The degree of import substitutability and the market power
affect the decision of firms to adjust their mark-ups as well. Furthermore,
transportation costs, tariffs and other trade barriers limit the degree of complete
pass-through (Obstfeld and Rogoff, 2000). Also, nominal price rigidities delay the
adverse effects of exchange rate shocks at least in the short run. Therefore, the
relationship between exchange rate and prices appears to be weak. Today in a
globalized world, much of the production process takes place in different countries,
so that the final price embodies in itself various currencies resulting in lower pass-
through (Mishkin, 2008).

In a macroeconomics perspective, inflation dynamics and volatility traditionally are
assumed to contribute to higher ERPT. However, in recent decade low and less
persistent level of inflation and stable monetary policy environment weakened the
relationship between exchange rate volatility and inflation. Especially under inflation
targeting regimes, anchored inflation expectations helped to mitigate possible
inflationary pressures of exchange rate shocks (Taylor, 2000). In addition, import
composition, openness and the size of a country are also among the main
macroeconomic determinants that accelerate the ERPT (McCarthy, 2000; Campa and
Goldberg, 2005).

3.1 Literature Review
While disentangling the effects of exchange rate shocks to prices, the attention is
mostly devoted to import prices at an aggregate and sectoral level rather than only
on CPI itself. It is the import price that transmits exchange rate shocks to the
economy through the price of imported goods. The major model specification used
for the ERPT analysis is based on the impulse response functions obtained from
vector autoregressive and error correction models. In some cases, structural models
(especially DSGE models) are employed to account for a wide range of possible
specific shocks in line with exchange rate shocks to inflation (Mishkin, 2008).

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