Monetary policy and exchange rates breakthrough of pass-through

Abstract: How should central banks react to movements in the exchange rate? Can social welfare be improved if the policy maker is giving explicit or implicit consideration to fluctuations in the exchange rate? These are some of the principal questions addressed in this thesis, which analyzes the influence of exchange rates on prices and monetary policy, from an empirical as well as a theoretical perspective. The thesis consists of four self-contained papers, and sets off by providing some empirical evidence for incomplete exchange rate pass-through. Incomplete exchange rate pass-through is subsequently incorporated into a theoretical model of a small open economy, to study how exchange rate fluctuations affect monetary policy.The first chapter is an empirical paper studying the relation between exchange rates and prices, using data on Swedish exports of automobiles and kraft paper. A price determining error correction model indicates results consistent with price discrimination and incomplete exchange rate pass-through.In the second chapter, a small open economy aggregate supply-aggregate demand model, allowing for incomplete exchange rate pass-through, is developed to analyze the effects of limited pass-through on monetary policy. The results suggest that the optimal policy reaction, both to foreign and domestic shocks, is dependent on the degree of exchange rate pass-through.The third chapter studies what the delegated monetary policy should be in an open economy with limited pass-through. In particular, the question of whether to delegate an exchange rate-stabilization objective to the policy maker is investigated. The results show that incorporation of an explicit nominal, or real, exchange-rate term in the (optimized) objective function only improves social welfare marginally.The fourth chapter assumes, in contrast, that monetary policy is implemented through a simple instrument rule. It is examined whether the policy maker’s performance, in terms of social welfare, can be improved by also responding to the exchange rate. The results indicate that the exchange rate-augmented policy rules do not outperform an optimized rule without the exchange rate, irrespective of the degree of pass-through. Social welfare is, however, improved by an indirect exchange rate response, which is reached using a policy rule based on Consumer Price Index (CPI) inflation, rather than on domestic inflation.