Nonlinear State and Shock Dependence of Exchange Rate Pass Through on Prices

This paper examines the nature of the pass-through of exchange rate shocks on prices along the distribution chain, and estimates its short and long-term path. It uses monthly data from a small open economy and a smooth transition auto-regressive vector model estimated by Bayesian methods. The main finding is that exchange rate pass-through is nonlinear and state and shock dependent. There are two main policy implications of these findings. First, models used by central banks for policymaking should take into account the nonlinear and endogenous nature of the pass-through. Second, a specific rule on pass-through for monetary policy decisions should be avoided