Theoretical Relationships:

1. Exchange Rate and Consumer Prices:

Domestic prices affected by exchange rate through two channels: direct and indirect. The

direct channels shows the direct effect of changes in import prices to changes in domestic prices

whereas in indirect channel, initially the domestic products become relatively cheaper for the

foreign consumers because of depreciation in domestic currency, as a result of which exports and

aggregate demand will increase which put an upward pressure on the domestic prices, Goldberg

and Knetter (1997).

There is an important connection between Exchange rate pass-through to consumer prices

and effectiveness of exchange rate as a shock absorber. Moreover, as some degree of flexibility

in exchange rate is required for inflation targeting, therefore, it will necessarily be a cause of

high exchange rate volatility, Edwards S.

Taylor (2000) suggests a hypothesis that low inflationary environment can lead to decline in

the extent of exchange rate pass-through to consumer prices in an economy. The hypothesis was

empirically tested by Chauhdri and Hakura (2001) for 71 countries, using data from 1979 to

2000, which resulted out to be significantly in favour of Taylor’s hypothesis.

2. Foreign CPI and Exchange Rate:

McFarlane (2002) explains the rise in consumer prices as a result of rise in demand for

exports because of depreciation in exchange rate. When there is an increase in the prices of

exports, it means that for foreign consumers, domestic products become expensive. Along with

the domestic inflation, foreign countries also have to face the inflationary damages. Therefore,

the changes in exchange rate not only effects domestic price, but also the foreign prices

associated with exports.

 3. CPI and FPI:

Domestic Consumer Prices are very adversely affected by foreign inflation. When there is

worldwide inflation, it means that the prices of the commodities are increased and where there is

a good sign for the exporters whose profits will increase, also there is long term damage in a way

that the imports also become expensive. And for the economy whose exchange rate is very much

depreciated, import payments will exceed the export bills, as a result of which the economy face

a current account deficit which leads to high inflation domestically. Also with the increase in

import prices, the domestic industry for import substitutes will charge higher prices on

consumers because of high cost of production. Salvatore D.

The main factors that are fond to influence the degree of pass-through are trade openness and

size of economy. According to Kent (1995), in the absence of other shocks, degree off pass-

through largely affects the demand elasticity of exports as compared to the supply elasticity.

4. Exchange Rate Misalignment and Consumer Prices:

Exchange rate misalignment is defined as a difference of exchange rate from its equilibrium

exchange rate. Misalignment can occur in all types of exchange rate regimes: fixed and flexible.

The deviation of market determined exchange rate may arise due to foreign exchange market

failures and high degree of exchange rate volatility. In order to control large divergence of Real

Effective Exchange Rate (REER) from its equilibrium exchange rate, there is need of central

bank to intervene and adjust the exchange rate accordingly, Zulfiqar H. and Mahboob A. (2006).

In such situation there is a wide chance of increase or decrease in inflation due to devaluation or

revaluation of currency by the central bank respectively.

 References:

Goldberg, P.K. and M.M. Knetter (1997), Goods prices and exchange rates: What have we
Learned?, Journal of Economic Literature 35 (3), 1243-1272.

Edwards, S. “The Relationship between Exchange Rates and Inflation Targeting Revisited”.

Taylor, J. (2000),“Low Inflation, Pass-through and Pricing Power of Firms”, European

Economic Review. Vol. 44, pp. 1389-1408.

Salvatore, D.“International Economics”11th Edition.

Kent, C. (1995), “Exchange Rate Pass-through: Testing the Small Country Assumption for
Australia”, Econometrics Paper.

McFarlane, L (2002), “Consumer Price Inflation and Exchange Rate Pass-Through In Jamaica”,
Bank of Jamaica.

Zulfiqar H., Mahboob A. (2006),“Equilibrium Real Effective Exchange Rate and Exchange Rate
Misalignment in Pakistan” SBP-Research Bulletin, Volume 2, Number 1, 2006.

RM

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