Does Exchange Rate Pass-Through Respond to Measures of Macroeconomic Instability?

Abstract

We argue that, theoretically, exchange rate pass-through (ERPT) into consumer prices may be nonlinear in contrast to standard linear estimates found in the literature. ERPT can be higher in periods of financial or confidence crises, when firms have no incentive to absorb cost increases in their margins. We test this hypothesis applying a logistic smooth transition (LSTR) model to Mexican data. Using two different measures of macroeconomic instability as transition variables, we find that ERPT does seem to increase in periods of macroeconomic distress, which highlights the importance of a stable macroeconomic environment in reducing ERPT in emerging markets.

JEL classification codes:

• E31
• E52
• F41

Key words:

• exchange rate pass-through
• smooth transition regression models
• emerging markets