CHAPTER ONE



The need for appropriate adjustment mechanism to structural imbalances in many developed countries, especially after the Great Depression of 1929-1933, culminated in extensive researches on exchange rate pass-through (ERPT) with the primary objective of determining a nominal anchor for inflation and inflation expectations. It is widely believed that an understanding of the impact of exchange rate movement on prices would help to gauge the appropriate monetary policy response to currency movements. The increased openness of most developed economies and the incidence of large fluctuations in nominal exchange rates have led to a need for a better understanding of the determinants of the transmission of exchange rate changes into import prices.

Exchange rate pass-through refers to the change in domestic prices that can be attributed to a prior change in the nominal exchange rate. In other words, it is the effect of a change in the exchange rate on domestic prices. Balance of payment postulations normally assume a one-to-one response of import prices to exchange rates, which is known as complete exchange rate pass-through (Peter, 2003). A one-to-one response of import prices to exchange rate changes is known as complete ERPT while a less than one-to-one response is known as partial or incomplete ERPT. The rate of ERPT has important implications for the effect of monetary policy on domestic prices as well as for the transmission of macroeconomic shocks and the volatility of the real exchange rate.

According to An, (2006) understanding of exchange rate pass-through is of extreme importance for three key reasons: First, the knowledge of the degree and timing of pass-through are essential for the proper assessment of monetary policy transmission on prices as well as for inflation forecasting. Second, the adoption of inflation targeting requires knowledge of the size and speed of exchange rate pass-through into inflations. Finally, the degree of exchange rate pass-through has important implication for “expenditure switching” effects from the exchange rate. In other words, a low degree of exchange rate pass-through would make it possible for trade flows to remain relatively insensitive to changes in exchange rates, though demand might be highly elastic.

In general, three factors may determine the extent of pass-through of exchange rate to domestic prices; the pricing behavior by exporters in the producer countries, the responsiveness of mark-ups to competitive conditions and the existence of distribution costs that may drive a wedge between import and retail prices (Oliver, 2002; Campa and Goldberg, 2005). For instance, when exchange rate changes, foreign firms can choose to pass exchange rate change fully to their selling prices in export markets (complete pass-through), to bear exchange rate change to keep selling prices unchanged (zero pass-through), or some combination of these (partial pass-through). In reality, exchange rate pass-through is far from complete, Goldberg and Knetter (1997) argued that “a price response equal to one half the exchange rate change”. They discovered that only around 60 percent of exchange rate changes are passed on to import prices in the United States.

The main explanation for incomplete pass-through is that many importing and exporting firms choose to hold their prices constant and simply reduce or increase the mark-up on prices, when the exchange rate is changing. Dornbusch (1987) justified incomplete pass-through as arising from firms that operate in a market characterized by imperfect competition and adjusts their mark-up (and not only prices) in response to an exchange rate shock. Burstein et al (2003) instead emphasized the role of (non-traded) domestic inputs in the chain of distribution of tradable goods. Furthermore, Burstein et al (2005) pointed out the measurement problems in CPI, which ignores the quality adjustment of tradable goods to large adjustment in the exchange rate. Another line of reasoning stresses the role that monetary and fiscal authorities play, by partly offsetting the impact of changes in the exchange rate on prices (Goagnon and Ihrig, 2004).

In Nigeria, the emphasis on knowing the exchange rate pass-through is underpinned by the fact that the Nigerian economy is external sector driven such that the shocks from global commodity markets have serious implications on the economy. In addition, the need to make the external sector competitive through appropriate exchange rate adjustment has made the study of exchange rate pass-through in Nigeria imperative. Recent developments in the external sector of the Nigerian economy revealed that the naira exchange rate depreciated by 24.0 percent between October 2008 and February 2009 and the pressure is still on as crude oil receipts continue to dwindle due to both demand and supply factors (CBN, 2010). Concerns are what the magnitude and interrelationship of exchange rate pass-through, monetary policy and price stability in Nigeria would be.





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