STATE BANK OF PAKISTAN WORKING PAPERS. Exchange Rate Pass-Through to Domestic Prices in Pakistan. Zulfiqar Hyder Sardar Shah

Transcription

1 STATE BANK OF PAKISTAN WORKING PAPERS No. 5 June 2004 Exchange Rae Pass-Through o Domesic Prices in Pakisan by Zulfiqar Hyder Sardar Shah

2 Sae Bank of Pakisan Working Paper No. 5, June 2004 Exchange Rae Pass-Through o Domesic Prices in Pakisan Zulfiqar Hyder Analys Research Deparmen Sae Bank of Pakisan, Karachi. zulfiqar.hyder@sbp.org.pk Sardar Shah Research Economis Research Deparmen Sae Bank of Pakisan Karachi sardar.shah@sbp.org.pk Absrac This paper assesses he exen o which he movemens in exchange rae affec domesic wholesale and consumer prices in Pakisan by analyzing daa from January 1988 o Sepember The empirical model is a recursive VAR, suggesed by McCarhy (2000), incorporaing a disribuion chain of pricing. Impulse response funcion and variance decomposiion are used o measure he exchange rae pass-hrough o domesic prices. The major findings of his paper are: (1) he exchange rae movemens have only a moderae effec on domesic prices, i.e., exchange rae pass-hrough is low; (2) he exchange rae pass-hrough is more sronger in wholesale price index (WPI) relaive o consumers price index (CPI); (3) he impac of pass-hrough on domesic prices spreads over 12 monhs, however, he effec is mosly fel in he firs four monhs; (4) he exchange rae pass-hrough o consumer prices have furher weakened afer he free floa of Rupee/Dollar pariy in July 2000; (5) wihin he WPI commodiy groups, he exchange rae pass-hrough is sronger in Fuel & Lighing and Manufacures groups while in he case of CPI, pass-hrough is more pronounced in Transpor & Communicaion and Fuel & Lighing group. Furhermore, he exchange rae pass-hrough o domesic prices is much sronger in higher inflaionary environmen during Jan-88 o Dec-97 relaive o lower inflaionary environmen down he road. Views expressed in his working paper are hose of he auhors and do no necessarily represen hose of he Sae Bank of Pakisan. The auhors would like o hank Riaz Riazuddin, Moinuddin, and Abid Qamar for heir helpful commens on iniial draf. Commens and suggesions are welcome by he auhors. 2

3 1. Inroducion The moneary policy in Pakisan aims a sabilizing he domesic and exernal value of he currency and o foser economic growh. Therefore, he exchange rae pass-hrough o domesic wholesale and consumer prices is an imporan link in he process of moneary policy ransmission. Since Pakisan s economy has a considerable degree of openness o foreign rade, he domesic price level canno remain immune o exernal price shocks i.e. exchange rae depreciaion/appreciaion and changes in impor prices. Any appreciaion or depreciaion of he exchange rae will no only resul in significan changes in he prices of impored finished goods bu also impored inpus ha affec he cos of he finished goods and services. Specifically, exchange rae movemens can influence domesic prices hrough direc and indirec channels (see Char 1). In case of direc channel, exchange rae movemens can affec domesic prices hrough changes in he price of impored finished goods and impored inpus. In general, when a currency depreciaes i will resul in higher impor prices while lower impor prices resul from appreciaion in price aker counries like Pakisan. The poenially higher coss of impored raw maerial and capial goods associaed wih an exchange rae depreciaion increase marginal coss and lead o higher prices of domesically produced goods. In case of indirec effec, he exchange rae depreciaion affecs he ne expors which in urn influence he domesic prices hrough he change in aggregae demand, puing upward pressure on domesic prices. In addiion, impor-compeing firms migh increase prices in response o foreign compeior price increases in order o mainain profi margins. However, he exen and he speed of exchange rae pass-hrough depends on several facors such as marke srucure, pricing policies, general inflaionary environmen, involvemen of non-radables in he disribuion of radables, relaive share of impors in WPI and CPI baske, ec. This paper assesses he exen o which exchange rae changes affec domesic prices in Pakisan. Specifically, we have focused on boh WPI and CPI inflaion by analyzing daa from January 1988 o Sepember The paper employs McCarhy (2000) recursive VAR mehodology ha provides a model o rack pass-hrough from exchange rae movemens o each sage of disribuion in a simple inegraed framework. Afer esimaing he VAR model, we generae impulse-response funcions in order o quanify he effec of an exchange rae shock on domesic prices. Variance decomposiion is hen used o rank he relaive share of exchange rae movemens for he explanaion of domesic price changes. 3

4 Char 1: Exchange Rae Pass-hrough o Domesic prices Pak Rupee Depreciaion Direc effecs Indirec effecs Impored inpus become more expensive in Pak Rupee Demand for Pakisani expors increases Impors of finished goods become expensive in Pak Rupee Producion cos rises Domesic price level increase a sa subsiue goods and expors becomes more expensive in Pak Rupee -Marke Srucure -Pricing policies -Produc subsiuabiliy -Involemen of various non-radables in he disribuion of radables -Slow adjusmen of non-radable prices and wages -Prevailing exchange rae policy -Inflaionary environmen The impulse response funcions and variance decomposiions indicae ha: (i) he exchange rae movemens have a moderae effec on domesic price inflaion or in oher words, exchange rae pass-hrough is low; (ii) i is found ha he exchange rae pass-hrough is more pronounced in WPI relaive o CPI; (iii) alhough he impac of he pass-hrough on domesic prices coninues over 12 monhs, i is mosly fel in he firs four monhs; (iv) he exchange rae pass-hrough o consumer prices have furher weakened afer he free floa of Rupee/Dollar pariy in July 2000; (v) a disaggregaed analysis of he WPI indicaes ha he pass-hrough of exchange rae movemens is sronger in Fuel & Lighing and 4

5 Manufacures groups while in he case of CPI, pass-hrough is more pronounced in he Transpor & Communicaion and Fuel & Lighing groups; (vi) he response of exchange rae movemens is weak in he case of he Food group in boh WPI and CPI. Furhermore, he exchange rae pass-hrough o domesic prices is much sronger in higher inflaionary environmen during Jan-88 o Dec-97. The paper is organized as follows. The nex secion presens a review of lieraure on exchange rae pass-hrough o domesic prices. Secion 3 describes he mehodology adoped for he analysis. The daa coverage, is sources and preliminarily saisical properies are presened in secion 4. The resuls from he impulse responses and variance decomposiions are presened in secion 5, and Secion 6 concludes. 2. Review of Lieraure There is a subsanial heoreical and empirical lieraure on he exchange rae pass-hrough o domesic producer and consumer prices, some of which has been surveyed in Goldberg and Kneer (1997). However, much of he lieraure has deal wih advanced economies. The sudies on exchange rae pass-hrough can be broadly divided ino hree caegories: (1) he firs caegory comprises sudies ha focus on examining exchange rae pass-hrough ino impor prices for specific indusries (for example, Feinberg, 1989, and Goldberg, 1995); (2) he second caegory includes sudies ha examine pass-hrough ino aggregae impor prices (for example, Hooper & Mann, 1989, and Campa & Goldberg, 2002); and (3) he hird caegory of sudies examines exchange rae pass-hrough ino WPI and CPI (for example, McCarhy, 2000; Papell, 1994; Heng, 1999; and Kim, 1998). Recenly, McCarhy (2000) recursive VAR framework 1, which incorporaes a disribuion chain of prices, has been widely adoped by a number of auhors for analyzing he exchange rae pass-hrough for various counries e.g. Ashok (2002) for Souh Africa; Leigh and Rossi (2002) for Turkey; and Rabanal and Schwarz (2001) for Brazil. Ashok (2002) finds ha he average pass-hrough is low and inflaionary impac of exchange rae depreciaion is absorbed a he inermediae sage of producion in Souh Africa. However, shocks o producer prices end o have a considerable impac on consumer prices. He also found ha pass-hrough is much higher for nominal raher han for real shocks. The findings of Leigh and Rossi (2002) are (i) he pass-hrough from he exchange rae o 1 McCarhy has analyzed he impac of exchange rae changes & impor price flucuaions on producer and consumer prices in six indusrialized OECD counries from 1976:1 o 1998:4. The impulse response funcion and 5

6 domesic prices coninues for a year bu is more inense in he firs four monhs (ii) he passhrough o WPI is more pronounced han CPI (iii) forecas of inflaion based on esimaes of he pass-hrough coefficien provides only parial informaion abou he underlying price pressures. Rabanal and Schwarz (2001) show ha afer 18 monhs abou wo-hirds of he iniial exchange rae shock is passed hrough o WPI and wo-ninhs o CPI in he case of Brazil, indicaing ha he pass-hrough o WPI is more pronounced as compared o he passhrough o CPI. Choudhri, Faruqee, and Hakura (2002) examine he performance of differen new open economy macroeconomic models in explaining he exchange rae pass-hrough in a wide range of prices. The resuls show ha he bes-fiing model incorporaes a number of feaures highlighed by differen srands of he lieraure: sicky prices, sicky wages, disribuion coss, and a combinaion of local and producer currency pricing. Lieraure Relaed o Pakisan Rehana and Naeem (1999) examine he impac of impored inflaion and changes in moneary and real variables on domesic prices during Coinegraion es is applied o deermine he long-erm relaionship and he causaliy beween he domesic price level and exchange raes. This sudy does no find any significan uni-direcional or bi-direcional causal relaionship beween changes in exchange rae and domesic prices. Eazaz and Saima (1999) explore he relaionship beween nominal exchange rae and domesic price level and also heir relaionship wih oher economic variables for Pakisan by using quarerly daa form 1982-II o 1996-IV. This paper races he paern and speed of adjusmen in he wo variables in response o differen ypes of shocks. Coinegraion mehod is used for he model esimaion, he findings of he sudy sugges ha one percen increase in price level of impor, wheher due o exchange rae devaluaion or rising world prices, resuls in 0.15 percen increase in CPI. Anjum Nasim (1997) uses annual daa from 1974 o 1994 and explores he main deerminans of inflaion in Pakisan. The price equaion used for esimaion is he general form of he price equaion by expressing he overall price level as weighed average of he price of radables and price of non-radables. The paper idenifies moneary growh and growh rae of foreign prices as he key deerminans of inflaion in Pakisan. I is found ha a 1 percen variance decomposiion show ha he exchange rae has a modes effec on domesic price over he pos-breon Woods era. He also found ha pass-hrough is somewha sronger in counries wih a larger impor share. 6

7 permanen increase in foreign prices resuls in a 0.14 percen increase in CPI in he firs year and 0.35 percen in he second year. While he long run impac is 0.32 percen. Hasan, Khan, Pasha and Rasheed (1995) invesigae he main deerminans of WPI inflaion in Pakisan. Disaggregaed price equaions are esimaed for food, raw maerials and manufacures. The esimaed price indices for hese hree caegories are combined wih wo oher sub indices aken o be exogenous o arrive a a predicion of WPI. The sudy concludes ha an increase in he procuremen price of whea, adminisered prices and exernal prices are he prime facors for inflaion in Pakisan. 3. Mehodology To examine he pass-hrough of exchange rae o domesic prices, his paper uilizes a recursive Vecor Auoregressive (VAR) approach proposed by McCarhy (2000). The model is based on six variables in he following order: oil price inflaion, oil (denominaed in he local currency) is used as a proxy for inernaional supply shock; demand shock, y is proxied by he Quanum Index of Manufacuring (QIM); he growh in money supply, M2; he change in nominal exchange rae, e; wholesale price inflaion, WPI ; and consumer price inflaion CPI. Π oil y = E e = E WPI CPI = E 1 1 M 2 = E Π Π 1 = E = E oil [ Π ] [ y ] 1 [ M 2 ] [ e ] 1 1 WPI oil y M 2 e WPI [ Π ] + δ1ε + δ 2ε + δ 3ε + δ 4ε + ε CPI oil y M 2 e WPI CPI [ Π ] + γ ε + γ ε + γ ε + γ ε + γ ε + ε + ε oil + α ε + λ ε oil 1 + ε + β ε oil 1 1 y oil 1 + λ ε + β ε y λ ε y 2 + ε M 2 3 This model considers pricing along he disribuion chain; inflaion a a paricular disribuion sage wholesale or consumer in period is assumed o be comprised of several differen componens. The firs componen is he expeced inflaion a ha sage based on he available informaion a he end of period 1. The second and hird componens are he effecs of supply and demand shocks on inflaion. The fourh componen is he growh in money supply, which is used o incorporae moneary policy in he model 2. The reasoning behind including moneary policy reacion funcion is: (1) in line wih he findings of Parsley and Popper (1998) and McCarhy (2000); hey found ha aking moneary policy in he analysis 3 M 2 + ε e T As moneary aggregae M2 is used as inermediae arge by SBP, herefore we also used growh in moneary aggregae o incorporae he cenral bank reacion funcion in our model. 7

8 significanly improves he esimaion resuls of exchange rae pass-hrough; (2) Cenral bank arges domesic inflaion in order o insulae prices from exchange rae movemens, herefore neglecing cenral bank behavior would disor he rue consequences of exchange rae variaion; and (3) recenly moneary policy is effecively used in order o he quell speculaions of exchange rae depreciaion in he inerbank marke. The fifh componen is he effec of exchange rae shocks on inflaion a a paricular sage followed by he effecs of inflaion shocks a previous sage of he disribuion chain. Finally, he model also includes he inflaion shock a ha paricular sage. 3 In order o recover he srucural shocks from he VAR residual, a Cholesky decomposiion of he residual variance-covariance marix is used (Hamilon, 1994). This decomposiion sems from a recursive assumpion where zero-resricions are imposed on he simulaneous correlaion among residuals. As a resul, he ordering of he variables is crucial. The inuiion of his decomposiion is ha a shock on he las ordered variable in he sysem does no conemporaneously affec he previous variables. More specifically, if he covariance beween various respecive innovaions associaed wih each variable in he model i.e. ε i is zero hen innovaion in any variable has an immediae effec on his variable and herefore impacs all fuure variables in he VAR model. However, usually, he covariance beween innovaions is no zero and hey have some common componen, which is generally aribued o firs variables in he VAR model. 4 Afer imposing he Cholesky decomposiion, wo ses of saisics are used o assess he passhrough from exchange rae flucuaions o domesic inflaion. Firs, impulse response of WPI and CPI inflaion o a one sandard deviaion shock of exchange rae are esimaed, which are subsequenly used in he calculaion of cumulaive pass-hrough coefficiens. 5 Second, variance decomposiion of WPI and CPI is used o assess how much of he (forecas) variance in domesic price indices over his period can be aribued o exchange rae flucuaions. 6 3 The inflaion shock a any sage is simply ha porion of inflaion ha canno be explained by using informaion from period 1 plus informaion abou supply and demand variables, money supply growh, exchange rae, and period inflaion a previous sages of he disribuion chain. 4 More echnically, he errors are orhogonalised i.e. Cholesky Decomposiion uses he inverse of he Cholesky facor of he residual covariance marix o orhogonalize he impulses. This decomposiion imposes an ordering of he variables in he VAR and aribues all of he effec of any common componen o he variable ha comes firs in he VAR sysem. The responses can change dramaically if we change he ordering of he variables. 5 An impulse response funcion races he effec of a one sandard deviaion shock o one of he innovaions on curren and fuure values of he endogenous variables. 6 Variance decomposiion separaes he variaion in an endogenous variable ino he componen shocks o he VAR. Thus, he variance decomposiion provides informaion abou he relaive imporance of each random innovaion in affecing he variables in he VAR. 8

9 In order o deermine he respecive impulse-response funcions, he variables need o be given a plausible ordering. The following ordering for he impulse-response analysis is used: Π oil y M2 e Π WPI Π CPI I may be noed ha McCarhy (2000) ranked he cenral bank reacion funcion las, as he assumed a reacive behavior of he cenral bank. However, we argue ha he posiion of M2 is prior o he wholesale prices. Given he long and variable lags of moneary policy, cenral banks usually reac o expeced inflaion raher han realized inflaion (forward-looking behavior). In his respec i would make sense o consider M2 prior o he wholesale price index and hus le prices reac o cenral bank policy, i.e. cenral banks se he arge of M2 afer observing leading indicaors for inflaion like oil prices, oupu changes ec. Addiionally, SBP also uses he moneary policy o appease he exchange rae flucuaions. However, we do no find significan changes due o a differen ordering of he M Daa and preliminarily saisical properies Daa used in his sudy is monhly from January 1988 o Sepember 2003, hus giving us a oal of 189 observaions. The source of he daa for all variables excep QIM and inernaional oil prices is he SBP Saisical Bullein, while QIM and inernaional oil prices are aken from he Inernaional Financial Saisics (IFS). 8 Before we proceed o esimae recursive VAR, i is imporan o esablish he order of inegraion of he series involved and hen selec he opimal lag lengh of he VAR model, which should be high enough o ensure ha he errors are approximaely whie noise, bu small enough o allow esimaion. The Augmened Dickey Fuller (ADF) uni roo es is used o deermine he saionariy of he variables in he sysem, which suggess ha all variables in logarihm have I (1) order of inegraion. The resuls of he ADF are presened in Table A1 of he Appendix. The VAR is esimaed in firs difference wih 3 lags as opimal lag lengh based on likelihood raio es. 5: Empirical Resuls The resul of impulse response funcions are described in Figure 1, from which i may be seen ha he exchange rae pass-hrough o domesic prices is quie low which is consisen wih esimaes repored in oher sudies of he pass-hrough in Pakisan [see Choudhri and Hakura (2001); and Eazaz and Saima (1999)]. The domesic prices boh WPI and CPI respond 7 We also compued pass-hrough coefficien and variance decomposiion by ranking he growh in money supply las, however, he resuls did no show any significan change. 9

10 immediaely rising for he firs four monhs afer a depreciaion shock o exchange rae and dwindle away gradually hereafer as measured by impulse response funcions and cumulaive pass-hrough coefficiens (see Figure 1 & Figure 2). 9 Figure 1: Impulse Responses of Domesic Prices o One Sandard Deviaion Innovaion in Exchange Rae ± 2 S.E. 10 Response of WPI o Innovaion in Exchange Rae percen Monhs Response of CPI o Innovaion in Exchange Rae.2 percen Monhs 8 The missing values of IFS s QIM are aken from SBP s Saisical Bullein and he base of hese indexes is adjused accordingly. 9 The pass-hrough coefficien is defined as: PT, +j =P, +j / E, +j where PT, +j and E, +j are cumulaive change in he price level and exchange rae respecively beween and +j monhs. 10 The dashed lines are 2 sandard error bands and esimaed using Mone Carlo mehod employed by Eviews 4.1 wih 100 repeiions. 10

11 percen WPI CPI Figure 2: Esimaed Cumulaive Pass-Through Coefficiens Monhs Figure 1 & Figure 2 also exhibi ha he effec of an exchange rae shock is more pronounced in he case of WPI relaive o CPI, wih as much as percen and percen of he exchange rae change being evenually refleced in WPI and CPI prices. The pass hrough coefficiens indicae ha afer four monhs, percen and percen of he exchange rae change have already been refleced ino wholesale and consumer prices respecively (see Table 1). This seems o be a manifesaion of: (1) he larger share of radable commodiies in WPI as compared o CPI; (2) CPI also includes services ha are generally no-raded and less affeced by exchange rae changes direcly; 11 and (3) i also implies ha exchange rae movemens have an effec on domesic prices hrough changes in he cos of producion, which emanae from price changes in impored inermediae goods. Table 1: Esimaed Cumulaive Pass-Through Coefficien of Domesic Prices WPI Inflaion Periods Jan-88 o Sep-03 Jan-88 o Jun-00 Jul-00 o Sep-03 Jan-88 o Dec-97 Jan-98 o Sep CPI Inflaion Tradable goods are defined as hose goods and services ha are impored/expored by a counry as well as hose goods and services ha are close subsiues for he exporable and imporable goods. The domesic prices of radable goods are deermined by he inernaional marke subjec o he ransporaion cos, ariff rae ec. On he oher hand domesic supply and demand forces exclusively deermine he domesic price of non-radables. 11

12 The cumulaive pass-hrough coefficien are also compued for sub-samples prior o and afer July 2000 o esimae he impac of free floaing of Rupee/Dollar pariy on exchange rae pass-hrough o domesic prices. The esimaed coefficiens of cumulaive pass-hrough of hese sub-samples indicae ha he exchange rae pass-hrough o consumer prices have dropped from 8.25 percen o 4.73 percen afer he free floaing of exchange rae (see Table 1). The sharp appreciaion of rupee/dollar pariy during laer par of he sub-sample and resulan srucural changes in he economy reversed he expecaions of he economic agens abou fuure exchange raes and hus impac heir price seing behavior. Surprisingly, he pass-hrough o wholesale pries merely increased from 9.95 percen o percen. Furhermore, we also es he hypohesis suggesed by Taylor (2000) ha he magniude of exchange rae pass-hrough o domesic prices depends on he general inflaionary environmen prevailing in he economy. As he exchange rae pass-hrough reflecs he expeced effec of exchange rae shock on he curren and fuure cos, a higher inflaionary environmen would end o increase he pass-hrough by srenghening he expeced fuure effec of he exchange rae shock. In case of Pakisan, he esimaed cumulaive pass-hrough coefficiens confirm his hypohesis during he relaively higher inflaionary period from Jan- 88 o Dec-97 relaive o lower inflaionary environmen down he road (see Table 1) amid he ighening of moneary policy and he appreciaion of rupee and he ample availabiliy of food producs. Resuls of Variance decomposiion, which show he conribuion of innovaion in he exchange rae o he variabiliy of boh WPI and CPI, are presened in Table 2, while he conribuions of oher explanaory variables are repored in Table A2 in appendix. Table 2: Variance Decomposiion of Domesic Prices Percenage of forecas error variance aribued o Exchange Rae shock: WPI Inflaion Forecas Horizon Jan-88 o Jan-88 o Jul-00 o Jan-88 o Jan-98 o Sep-03 Jun-00 Sep-03 Dec-97 Sep CPI Inflaion

13 As shown by Table 2, he exchange rae shock only explains 3.63 percen and 2.41 percen of he forecas error variance of WPI and CPI respecively, while he remainder of he variance of WPI and CPI inflaion is explained by innovaions in oher variables (see Table 2 in Appendix). Specifically, percen of he variance is explained by is own innovaion followed by indusrial oupu growh which explains 4.49 percen of variance. In case of CPI, apar from percen of variance explained by is own impac, percen of variaion is explained by wholesale prices followed by money supply growh. The variance decomposiion of sub-samples shows ha he explanaion of forecas error variance due o exchange rae remains unchanged in case of WPI before and afer he free floa, while he share of exchange rae in explanaion of forecas error variance declined in low inflaionary environmen (see Table 2). On he oher hand, he share of exchange rae in explaining forecas error variance of CPI increased in boh sub-samples. In order o invesigae which commodiy group in WPI and CPI is more sensiive o exchange rae flucuaions, a disaggregaed analysis is also carried ou. Three commodiy groups of WPI; Food, Manufacures and Fuel & Lighing groups are invesigaed and resuls show ha Fuel & Lighing group is more sensiive o exchange rae changes compared wih Food and Manufacures groups (see Table A3 and Figure A2 in Appendix). The resuls are also verified from cumulaive exchange rae pass-hrough coefficiens, which exhibi 33 percen and 14 percen of he exchange rae change being evenually refleced in Fuel & Lighing and Manufacures groups respecively and he pass-hrough effec is mosly fel in firs four monhs (see Figure A2). In case of Food group, he governmen policy of announcing procuremen price for whea has a greaer impac on food prices han exchange rae movemens. 12 On he oher hand, Fuel & Lighing group prices are more sensiive o exchange rae changes as governmen promply shifs he increase in domesic prices. Recenly, he governmen has delegaed he funcion of deermining oil prices o he Oil Companies Advisory Commiee (OCAC), which reviews he oil prices on fornighly basis. As far as group wise analysis of CPI is concerned, hree groups; Food & Beverages, Fuel & Lighing and Transpor & Communicaion are invesigaed. The variance decomposiion analysis shows ha Transpor & Communicaion group is more suscepible o exchange rae changes followed by Fuel & Lighing group, while he Food group is less sensiive o 12 In order o provide suppor o farmers, he governmen announces he procuremen prices for whea, sugarcane and coon and buys hese crops a ha price, which may be differen from he marke price. 13

14 exchange rae movemens (see Table A4, Figure A1 & A2 in Appendix). The esimaed cumulaive pass-hrough coefficiens show ha 58 percen and 27 percen of he exchange rae change is evenually refleced in Transpor & Communicaion and Fuel & Lighing groups respecively and he pass-hrough effec is mosly fel in firs four monhs (see Figure A2). 6. Conclusion In his paper, we use a recursive VAR model suggesed by McCarhy (2000) on monhly daa from January 1988 o Sepember The findings of he paper sugges ha: (1) he exchange rae movemens have a moderae effec on domesic price inflaion mainly due o higher share of whea, sugarcane, coon and energy in WPI and CPI baskes which are subjec o procuremen and adminisraed prices of governmen; (2) he exchange rae passhrough is more pronounced in WPI as compared o CPI due o he higher share of radables in WPI baske relaive o CPI baske; (3) he impac of pass-hrough on domesic prices spreads over 12 monhs, however, he effec is more pronounced in he firs four monhs as indicaed by pass-hrough coefficiens of WPI and CPI; (4) he exchange rae pass-hrough o consumer prices have furher weakened afer he free floa of Rupee/Dollar pariy in July 2000 and resulan srucural changes in he economy; (5) wihin he WPI commodiy groups, he pass-hrough of exchange rae movemens is sronger in Fuel & Lighing and Manufacures groups while in he case of CPI, pass-hrough is more pronounced in Transpor & Communicaion and Fuel & Lighing group; (6) no surprisingly, he response of exchange rae movemens in he Food group is weak boh in he case of WPI and CPI. This resul, which shows a low exchange rae pass-hrough o domesic prices, has an imporan implicaion for he moneary policy implemenaion. Low exchange rae passhrough provides greaer freedom for pursuing independen moneary policy especially hrough inflaion argeing regime. 14

15 References Anjum Nasim (1997), Deerminans of inflaion in Pakisan, Sae Bank of Pakisan. Bhundia, Ashok J (2002) An Empirical Invesigaion of Exchange Rae Pass-Through in Souh Africa, Working Paper No. 02/165, IMF. Campa, José Manuel and Linda S. Goldberg Exchange Rae Pass-Through ino Impor Prices: A Macro or Micro Phenomenon? Working Paper No. 8934, Naional Bureau of Economic Research, USA. Choudhri, Ehsan U ; Faruqee, Hamid ; Hakura, Dalia S (2002) Explaining he Exchange Rae Pass-Through in Differen Prices, Working Paper No. 02/224, IMF. Choudhri, Ehsan U and Hakura, Dalia S (2001) Exchange Rae Pass-Through o Domesic Prices: Does he Inflaionary Environmen Maer?, Working Paper No. 01/194, IMF. Eazaz Ahmad and Saima Ahmed Ali (1999), Exchange Rae and Inflaion Dynamics, Pakisan Developmen Review, Vol: 38, No: 3. Feinberg, Rober M (1989) The Effecs of Foreign Exchange Movemens on U.S. Domesic Prices, Review of Economics and Saisics, Vol. 71, No. 3, pp Hooper, Peer and Caherine L. Mann Exchange Rae Pass-Through in he 1980s: he Case of U.S. Impors of Manufacures, Brookings Papers on Economic Aciviy, 1. Goldberg, P.K. (1995). Produc Differeniaion and Oligopoly in Inernaional Markes: The Case of he U.S. Auomobile Indusry, Economerica, Vol. 63(4), pp Goldberg, P. K. and Kneer M. M. (1997): Goods Prices and Exchange Raes: Wha Have We Learned?, Journal of Economic Lieraure, Vol. 35, No. 3, pp Hamilon, James D. (1994), Time Series Analysis, Princeon Universiy Press. Hasan, M.Aynul, Ashfaque H. Khan, Hafiz A. Pasha and Aijaz Rasheed (1995), Wha Explains he Curren High Rae of Inflaion in Pakisan?, Pakisan Developmen Review, Vol: 35, No: 4. McCarhy, Jonahan (2000) Pass-Through of Exchange Raes and Impor Prices o Domesic Inflaion in Some Indusrialized Economies, Saff repors No.11, Federal Reserve Bank of New York. Kim, Ki-Ho (1998): US Inflaion and he Dollar Exchange Rae: A Vecor Error Correcion Model, Applied Economics, Vol. 30, pp Leigh, Daniel, Rossi, Marco (2002) Exchange Rae Pass-Through in Turkey, Working Paper No. 02/204, IMF. Parsley, D.C. and H.A. Popper (1998), Exchange raes, domesic prices, and cenral bank acions: recen U.S. experience, Souhern Economic Journal, 64 (4), pp

16 Rabanal, P., and G. Schwarz (2001), Exchange Rae Changes and Consumer Price Inflaion: 20 monhs afer he floaing of he Real in Brazil: Seleced Issues and Saisical Appendix, IMF Counry Repor N0. 01/10, IMF. Siddiqui, Rehana and Akhar, Naeem (1999), The Impac of Changes in Exchange Rae on Prices: A Case Sudy of Pakisan, Pakisan Developmen Review, Vol: 38, No: 4. Taylor, John (2000), Low Inflaion, Pass-hrough, and he Pricing Power of Firms, European Economic Review, Vol: 44, pp

17 Appendix I: Table A1: Augmened Dickey Fuller Tes (Uni Roo) Level Firs Difference Order of Inegraion LOILP (3) (2)* I(1) LINDY (2) (2)* I(1) LER (1) (1)* I(1) LWPI (1) (0)* I(1) LCPI 0.97 (1) (0)* I(1) LM2-1.17(1) (1)* I(1) (*) Significan a 1 percen Table A 2: Variance Decomposiion of Domesic Inflaion Percenage of forecas error variance aribued o: WPI Inflaion Forecas Horizon Oil prices Indusrial oupu growh Money supply Exchange rae WPI CPI CPI Inflaion Table A3: Variance Decomposiion of WPI Inflaion: By Commodiy Group Percenage of forecas error variance aribued o Exchange Rae: Forecas Food Manufacures Fuel, Lighing & Lubricans Horizon

18 Table A4: Variance Decomposiion of CPI Inflaion: By Commodiy Group Percenage of forecas error variance aribued o Exchange Rae: Forecas Food & Beverages Fuel & Lighing Transpor & Communicaion Horizon Figure A1: Esimaed Cumulaive Pass-Through Coefficiens: Group-Wise WPI: Food WPI: FL WPI: Manufacurers percen Monhs CPI: TC CPI: FL CPI: Food percen Monhs 18

19 Figure A2: Impulse Response Funcions of WPI & CPI Inflaion: Group-Wise WPI: Food Group WPI: Fuel, Lighing & Lubricans Group percen percen Monhs WPI: Manufacures Group Monhs CPI: Food Group percen percen Monhs CPI: Transpor & Communicaion Group percen percen Monhs CPI: Fuel & Lighing group -.2 Monhs -.4 Monhs 19