The First and Second Stage Pass-through of Exchange Rates: A Developing Country Perspective

This paper investigates the validity of the conventional wisdom that, unlike in developed countries, exchange rate pass-through (ERPT) should be ‘complete’ for developing economies. To test this hypothesis, we construct new variables as well as original data sets, which are not readily available in the literature, and employ an alternative error correction model technique for a typical small open developing economy—Bangladesh. The transmission of exchange rate movements to import prices is found to be ‘complete’; however, the ‘second stage pass-through’ is ‘partial’ both in the short and long run. The response of traded goods prices to exchange rate shocks is found to be significant and larger in the long run compared with the short run. Trade liberalization is also a significant phenomenon for ERPT. The analysis has wider applicability to other small open economies.