US inflation and the dollar exchange rate: a vector error correction model

Many studies investigating the relation between inflation and exchange rates have found that exchange rates influenced inflation, while other studies have failed to do so or reported mixed results. These findings, however, might be spurious as the majority of the earlier investigations suffered from misspecifications of one kind or another. The current paper addresses the problem by employing an up-to-date and powerful cointegration method developed by Johansen (1988). In a system of five-equation vector error correction model, this paper finds that the US inflation, exchange rate, money supply, income, and interest rate are cointegrated. The cointegration analysis of the data covering the 1973-95 period reveals that the dollar exchange rate has a significant negative impact on the inflation measured by the producer price index. It is further established that the exchange rate Granger causes the inflation.