Exchange Rate Pass-through to Domestic Prices

Abstract

This study makes an attempt to examine the exchange rate pass-through (ERPT) to domestic prices in the post-reform period in India. It also analyzes the effect of global financial crisis of 2007 on the ERPT. It has used the standard vector auto-regression (VAR) model taking five variables (viz., exchange rate, oil price, output gap, money supply and wholesale price index (WPI)) for analysis. Using impulse response function, the study finds that a 10 per cent depreciation in rupee (`) results in 0.011 per cent rise in WPI after one month. It found moderate ERPT estimates ranging from 0.01112 per cent (after first month) to 0.01197 per cent (after six months). The cumulative pass-through is found to be 0.07 for one month, it is stabilized at 0.06. The main drivers of price change are identified through variance decomposition. Persistently rising WPI and the oil price hike are found as the main drivers of price rise. Pressure of exchange rate on the WPI is found to be very modest, that is, about 7 per cent. Using the Quandt-Andrews Unknown Breakpoint test, the study found a structural break at November 2007, but the effect of the crisis on ERPT is found to be insignificant. The study explains the low ERPT in terms of India’s large import size and its composition in favour of raw materials and intermediary goods, exchange rate volatility and moderate inflation. It reduces the apprehension of domestic price instability arising from the floating exchange rate.