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

• DOI: http://doi.org/10.1111/rode.12105
• Date: 01 August 2014
• Author: Somnath Sen,Nick Horsewood,M. Nusrate Aziz
• Published date: 01 August 2014

The First and Second Stage Pass-through of

Exchange Rates: A Developing Country Perspective

M. Nusrate Aziz, Nick Horsewood, and Somnath Sen*

Abstract

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 hypoth-

esis, we construct new variables as well as original data sets, which are not readily available in the litera-

ture, 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 ‘com-

plete’; 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.

1. Introduction

Exchange rate pass-through (ERPT) analyses the impact of exchange rate movements

on domestic prices. Although there exists an extensive empirical literature on ERPT

for the macroeconomy, few papers have explored this issue from the perspective of

developing countries. However, for developing economies, the investigation of ERPT

to import prices is an important issue. First, most developing countries have been pur-

suing an export-led growth strategy wherein exchange rates policy is expected to play

a very active and key role. Second, most of the emerging economies import technol-

ogy and other capital goods for their exporting industries. Given this, exchange rate

devaluation leads to an increase in demand for exports which, in turn, increases the

overall demand for imports at the same time. Prices of imports and its relationship

with exchange rate depreciation are therefore important for an economy following

export-promoting industrialization. If viewed from this perspective, ERPT to import

prices becomes a significant area of study especially for developing countries. Not

only that, as import prices is one of the principal channels through which the

exchange rate affects domestic prices (Olivei, 2002; Marazzi et al., 2005; Mumtaz et

al., 2006), the pass-through of exchange rate changes to domestic prices can be an

important indicator for any country. Third, therefore, ERPT may ultimately have

implications for the appropriate outlook towards inflation-forecasting and monetary

policy (Taylor, 2000; Marazzi et al., 2005) as well as the external trade policy of an

economy.

By ‘exchange rate pass-through’ (ERPT) we mean the percentage changes in the

import and domestic prices (in local currency terms) in response to a 1% change in

the exchange rate. If the response is one-to-one, the pass-through is known as ‘com-

* Aziz: Graduate School of Management, Multimedia University, Cyberjaya 63100, Malaysia. Tel: +603-

8312-5955; Fax: +603-8312-5699; E-mail: nusrate@yahoo.com. Horsewood: Department of Economics, Uni-

versity of Birmingham, B15 2TT, UK. Sen: Department of Economics, University of Birmingham, B15

2TT, UK.

Review of Development Economics, 18(3), 595–609, 2014

DOI:10.1111/rode.12105

© 2014 John Wiley & Sons Ltd