Introduction
Conventional wisdom in international finance and open economy macroeconomics suggests that exchange rates affect the economy mainly through changes in competitiveness and associated trade flows (Baxter 1995; Obstfeld and Rogoff 1995). This “trade channel of the exchange rate” seems to well explain the macroeconomic effects of exchange rate changes in advanced economies, for which exchange rate depreciations are typically followed by increases in economic activity and prices. In contrast, currency depreciations in emerging market economies can be inflationary and, at the same time, reduce economic activity (Calvo 2002). The contractionary nature of exchange rate depreciations in emerging market economies largely results from currency mismatches in the form of liability dollarization (Cook 2004). At the same time, a growing literature shows that changes in financial conditions resulting from exchange rate fluctuations affect the transmission of exchange rate fluctuations to broader macroeconomic conditions in emerging market economies and pose difficult trade-offs to central banks (Carstens and Shin 2019). At best, global financial integration creates a trade-off between macroeconomic stabilization and financial stability during significant swings in the exchange rate, thereby reducing the effectiveness of monetary policy (Obstfeld 2021). In the worst-case scenario, countries with open capital accounts cannot have an independent monetary policy, regardless of their exchange rate regime (Rey 2015).1
This chapter systematically estimates differences in the exchange rate pass-through to output and prices between advanced economies and emerging market economies. To do so, we identify exogenous shocks to the nominal bilateral exchange rate against the US dollar for 38 currencies by using Hofmann, Shim, and Shin’s (2020) high-frequency identification approach. We then estimate panel regressions for prices and GDP by using local projection techniques (Jordà 2005) on a sample of 24 advanced economies and 26 emerging market economies between the first quarter of 2002 and the fourth quarter of 2019.2 After quantifying the differential impacts of exchange rate shocks on emerging market economies compared to advanced economies, we test whether the responses to shocks are symmetric. We have two main findings.
Our first finding is that exchange rate shocks elicit a larger response of prices in emerging market economies than in advanced economies and move output in opposite directions in these two types of countries (that is, an appreciation increases output in emerging market economies and reduces it in advanced economies). To our knowledge, this work is the first that systematically estimates the differences between advanced and emerging market economies in terms of exchange rate pass-through to prices and output. The differences between advanced and emerging market economies are more pronounced if we use the US dollar bilateral rate instead of the nominal effective exchange rate (NEER), which suggests a role for balance sheets and credit. We investigate the response of private credit to an exchange shock and find it to be in line with the balance sheet channel.3
Our second finding is that the differences in pass-through between these two types of economies are mostly driven by the reaction of output and inflation during currency depreciations. We find that when an emerging market currency depreciates against the US dollar, prices rise significantly in the near term while output falls, but this response is not symmetric to the one observed when the domestic currency appreciates. In fact, during currency appreciations, prices fall significantly only after 10 quarters, and output does not respond significantly. Two mechanisms could be behind this asymmetry. The first mechanism relies on currency mismatches among domestic firms, households, or financial intermediaries that cause borrowing constraints to bind when a currency depreciates against a reserve currency. The second mechanism is that of Gopinath and others’ 2020 dominant currency pricing, whereby the traditional expenditure switching mechanism is mostly absent in economies that rely on a dominant currency (for example, the US dollar) for invoicing and pricing in international trade.
This chapter relates to the literature on state-contingent exchange rate pass-through. For example, Forbes, Hjortsoe, and Nenova (2018) note that the pass-through from exchange rates to inflation depends on what is driving the exchange rate change (that is, domestic demand or monetary policy). In addition, it relates to papers on endogenous pass-through that show the exchange rate and pass-through to be jointly determined (Devereux, Engel, and Storgaard 2004). This chapter contributes as well to an expanding literature on the effects of currency depreciations and financial crises on firm leverage, debt, and investment (Aguiar 2005; Bleakley and Cowan 2008; Kalemli-Ozcan, Kamil, and Villegas-Sanchez 2016; Kalemli-Ozcan, Liu, and Shim 2021). Our results also add to the literature on the state-contingent nature of the transmission of macroeconomic shocks more broadly and, in particular, that of monetary policy socks (Angrist, Jordà, and Kuersteiner 2018; Tenreyro and Thwaites 2016). Finally, our findings support the hypotheses of balance sheet/financial channels of exchange rate adjustments (Bruno and Shin 2015; Gabaix and Maggiori 2015; Hofmann, Shim, and Shin 2020).
The rest of the chapter is organized as follows. The second section presents our data and econometric methodology. The third section documents the impact of exchange rate shocks on inflation and output in advanced and emerging market economies. The final section concludes and discusses future research.
Data Sources and Methods
Data
Our data cover 50 emerging market economies and advanced economies (Annex Table 7.1.1) at the quarterly frequency between the first quarter of 2002 and the fourth quarter of 2019. Data on GDP, consumer price indexes (CPIs), producer price indexes, and exchange rates are from the IMF’s World Economic Outlook and International Financial Statistics databases. Data on commodity prices and import prices are from Haver Analytics. Data on credit are from the Bank for International Settlements, and data on real house price and domestic financial condition indices come from IMF’s Global Financial Stability Report (IMF 2017). Trade openness is measured by the ratio of imports plus exports to GDP, available from the World Bank. We use the three-month money market rate from Refinitiv Datastream as a proxy for the domestic interest rate. Finally, to build rolling four-quarters-ahead inflation and GDP growth expectations, we collect data on same-year and next-year GDP growth and CPI inflation expectations from Consensus Forecasts.4
Econometric Approach
We use Jordà’s 2005 local projections method to estimate the response of output and prices to exchange rate movements. The specification that we use to investigate the differential impact of exchange rate shocks on output and inflation in emerging market economies and advanced economies is as follows:
where yit is the log output or log CPI in country i at quarter t, and Sit is either the NEER or the bilateral nominal exchange rate against the US dollar. Following Hofmann, Shim, and Shin (2020), the variable η(S) is an exchange rate shock equal to change in the exchange rate between the day before and the day after monetary policy announcements by the Federal Reserve or the European Central Bank (Hofmann, Shim, and Shin 2020). I(iEMD) is an emerging market dummy, and Zit is a vector of country-specific and global controls, including the commodity price index, the measure of trade openness, and the domestic interest rate. To control for the effects of the global financial crisis (GFC), we also use pre-GFC and GFC dummies. αi is a country’s fixed effect. Given that T is large, we estimate (7.1) with the within estimator.5 The estimates of the impulse response function of output or prices are given by the estimates of the coefficient β1 for various horizons h.
Exchange Rate Pass-Through
Transmission to Inflation and Output
We first run regression (7.1) on a panel of 50 advanced economies and emerging market economies. Figure 7.1 presents the response of inflation and output to an exchange rate appreciation shock in advanced economies and emerging market economies. In line with previous studies, we find that a positive (appreciation) shock to the bilateral exchange rate against the US dollar has a deflationary impact on advanced economies and emerging market economies. In advanced economies, an exchange rate shock has a pass-through of about 5 percent to CPI, but the impact on prices is not statistically significant. In emerging market economies, however, an exchange rate appreciation triggers a much larger and persistent fall in prices. The peak effect on prices is about 25 percent and occurs after about a year. Our results also suggest that the deflationary pressures are statistically significant up to 9 or 10 quarters in emerging market economies (Figure 7.1, panel 1). In terms of real activity, an unexpected appreciation against the US dollar results a fall in output in advanced economies. Although the effect is estimated to be small, it is consistent with the standard exchange rate channel, which operates via expenditure switching of domestic agents toward imported goods. From a monetary policy perspective, a fall in output combined with deflationary pressures following the shock—that is, the positive co-movement between inflation and output—would call for a standard monetary policy response. By easing monetary policy, the central bank could cushion the effects of the exchange rate appreciation on output and on inflation.
CPI and GDP Responses to an Exchange Rate Shock in EMs and AEs
Source: Authors’ calculations.Note: AEs = advanced economies; CPI = consumer price index; EMs = emerging markets.In contrast to advanced economies, the exchange rate shock is associated with an increase in output in emerging market economies. Following the shock, output increases persistently and stays above the preshock level for more than one year. This result is at odds with standard transmission channels of exchange rates.
The results are robust to identifying the exchange rate shock with the response of exchanges after monetary policy announcements using a one-day window instead of two days.6 These results are also robust to using a domestic financial conditions index instead of the money market rate.
To shed light on the response of output in emerging market economies, we estimate (7.1) using credit as the dependent variable. Figure 7.2 presents the estimated response of credit to the exchange rate shock. Although credit expands in advanced economies and in emerging market economies, the increase is much larger in emerging market economies and likely more than compensates for the negative effect of exchange rate appreciations on output via the trade channel.
Domestic Real Bank Credit Response to an Exchange Rate Shock
Source: Authors’ calculations.Note: AE = advanced economy; EM = emerging market.The positive response of output to positive exchange rate shocks seems to be driven by a long-lasting credit expansion driving the aggregate demand up, consistent with the evidence presented, for example, in Nier, Olafsson, and Rollinson (2020). The easing of financial conditions poses a difficult trade-off for monetary policy in emerging market economies. Although the disinflationary impact of exchange rate appreciations would call for an easing of monetary policy, easier financial conditions and the expansion of credit could limit the desire and latitude of the central bank to further ease financial conditions.
Financial conditions could be directly affected by exchange rate fluctuations in emerging market economies for several reasons. One condition by which to observe this type of response to shocks to the exchange rate is the presence of significant currency mismatches in public and private balance sheets or, even in the absence of large foreign exchange mismatches, a large share of foreign investors in domestic debt markets (Blanchard, Cerutti, and Summers 2015; Carstens 2019; Ghosh, Ostry, and Qureshi 2018; Hofmann, Shim, and Shin 2020; Shin 2018). In that case, the effect of the exchange rate would affect the net worth of borrowers and their credit demand. Conversely, exchange rate fluctuations may also affect the supply of credit. For example, a sharp depreciation of the domestic currency could adversely affect the returns on investment for foreign lenders in terms of foreign currency, possibly leading to a reduced supply of credit for the domestic economy (Carstens and Shin 2019). A depreciation could also directly affect the credit supply of domestic lenders through the portfolio choice of global investors, as local currency bond spreads, credit risk premiums, and capital outflows increase when the exchange rate depreciates (Hofmann, Shim, and Shin 2020).
The literature on the financial channel of the exchange rate and on the currency denomination of trade flows assigns a special role to movements in the US dollar in driving financial conditions in emerging market economies (for example, Gopinath and others 2020; Hofmann, Shim, and Shin 2020). To verify whether this view is accurate, in our sample, we estimate (7.1) using exchange rate shocks derived from movements in the NEER instead of the bilateral US dollar exchange rate. Following Hofmann, Shim, and Shin (2020), in addition to using NEER-based shocks, we also orthogonalize NEER shocks to US dollar shocks (that is, residuals from regressions NEER shock on bilateral US dollar exchange rate shock). Our results, presented in Figure 7.3, confirm the special role of the US dollar. The response of emerging market economies’ output to NEER shocks is not significant, and when we orthogonalize the NEER shock, the point estimates suggest a negative response of output.
GDP Responses to a NEER Shock in EMs
Source: Authors’ calculations.Note: EM = emerging market; NEER = nominal effective exchange rate.Finally, we run a number of alternative specifications to better understand our baseline results for emerging market economies and, in Figure 7.4, plot the estimated impulse response functions against those estimated by using our benchmark specification (black line). Although the results presented in Figure 7.4 show that small changes to our benchmark specification (7.1) do not have a large impact, qualitatively or quantitatively, on our baseline inference (especially for CPI inflation), some small changes are worth discussing. The first exercise uses the NEER component that is orthogonal to the bilateral exchange rate against the US dollar (that is, that to a larger extent captures the trade channel of the exchange rate). The red line in Figure 7.4 is inside the 90 percent confidence band of the benchmark response, but the point estimates of the GDP response are smaller, which supports the view that the dollar plays a special role and highlights the importance of the financial channel. The second exercise excludes the GFC dummies, and the results (blue line) are in line with the view that the GFC is not an emerging market crisis (or, at least, not an emerging market currency crisis; see Park and Mercado 2014). Finally, we remove the crisis dummies and find that the impulse response of the GDP (green line) is smaller than the benchmark one (but still inside the confidence bands) and mostly not statistically different from zero (not reported), which is in line with the view that the balance sheet channel of the exchange rate is more present during crises.
CPI and GDP Responses to an Exchange Rate Shock in EMs: Robustness
Source: Authors’ calculations.Note: CPI = consumer price index; EM = emerging market; GFC = global financial crisis.In sum, the results presented in this section confirm findings of the past literature on the exchange rate pass-through to output in emerging market economies and how it differs from that of advanced economies (for example, Calvo 2002). At the same time, to our knowledge, our work is the first to document the opposite impact of the bilateral US dollar exchange rate shocks on prices and output in this group of countries, resulting in an important monetary policy trade-off. This result is also consistent with the importance of the financial channels of exchange rate in emerging market economies.
Asymmetric Pass-through
The results presented above hint at the importance of balance sheet effects for the pass-through of exchange rate movements. These balance sheet effects can be, in theory, induced by financial frictions that arise from costly state verification (for example, Eaton and Gersovitz 1981), which amplify the effects of shocks that change (reserve currency denominated) collateral values. When the collateral constraints always bind, the effects of currency depreciations and appreciations should be symmetric because they either decrease or increase the net worth of borrowers (for example, Calvo 1998). However, if we consider that collateral constraints only occasionally bind (Kiyotaki and Moore 1997) and that they are more likely to bind or only bind when the currency depreciates, then we should expect the pass-through of currency depreciations to be different (and larger) than that of appreciations (for example, Céspedes, Chang, and Velasco 2004; Mendoza 2010).7
We therefore explicitly test the possibility of an asymmetric pass-through of the exchange rate shock to output and prices by modifying (7.1) to differentiate between depreciations and appreciations. We estimate the following specification:
where I+ (η(Si,t)) and I- (η(Si,t)) are indicator variables that take values of 1 or –1 if there is an appreciation and depreciation shock, respectively, and zero otherwise. The null hypothesis that we would like to test is that of symmetric pass-through, or
The results of estimating (7.2) for the sample of emerging markets only are depicted in Figure 7.5. In this figure, the chart in panel 1 shows that prices rise with a depreciation of the domestic currency against the dollar and fall in the case of an appreciation. The chart in panel 2 shows that a currency depreciation is contractionary (at the 10 percent level of statistical significance), but an appreciation has an effect on output that is not statistically different than zero.
CPI and GDP Asymmetric Responses to Appreciation/Depreciation against the US Dollar
Source: Authors’ calculations.Note: CPI = consumer price index.Taken together, these results suggest that when currencies appreciate, there are two offsetting effects on aggregate demand: a contractionary expenditure switching or trade competitiveness effect and an expansionary balance sheet effect. For inflation, one needs to add a direct translation effect on prices because import prices that are set in a foreign currency fall when measured in a domestic currency. All in all, when the domestic currency appreciates, the tendency for prices to fall because of simple translation effects or because of the trade channel effect is only partially offset by the inflationary effect of higher aggregate demand driven by balance sheets. When the domestic currency depreciates, the effects reverse but otherwise play out in similar fashion: the inflationary pressure coming from the price translation and balance sheet channels is only partially reversed by the deflationary effect of the trade channel. In line with this result, the estimated response functions in panel 1 of Figure 7.5 do not provide much support for an asymmetric response of inflation to exchange rate shocks: prices rise significantly during a depreciation shock and fall moderately during an appreciation, and only after a long lag.
However, for output, there is strong evidence of an asymmetric response. In depreciations, the balance sheet effects are comparably stronger, as they more than offset the trade effects on output, and output falls significantly (Figure 7.5, panel 2). When the exchange rate appreciates, though, the trade effects and the balance sheet effects cancel each other out, and there is no measurable response of output at the usual statistical significance levels. Thus, overall, these results argue in favor of models with occasionally binding collateral constraints.
Conclusion
We show that exchange rate shocks move inflation countercyclically in emerging markets. We also show that this movement happens mostly for exchange rate depreciations, which is what one would expect if occasionally binding borrowing constraints stemmed from currency mismatches. This work also has important implications for models of international transmission with a nontrivial role for exchange rate movements, in particular the bilateral rate against the US dollar. Our results support the quantitative importance of the balance sheet channel of exchange rates without ruling out Gopinath and others’ 2020 “Dominant Currency Paradigm” hypothesis. From a policy perspective, the fact that inflation rises and output falls in response to a depreciating exchange rate creates a difficult trade-off for central banks. This dilemma raises important questions about what central banks can do to respond to such shocks (for example, Vegh and others 2017), which should be researched further.
Our results are consistent with the literature on the role of leverage and collateral constraints in determining the effects of exchange rate fluctuations. For instance, Kalemli-Ozcan, Liu, and Shim (2021) show that currency mismatches in firms’ balance sheets amplify the effects of exchange rate movements, especially during depreciation episodes. However, easing macroprudential policy in this instance can improve this trade-off because it relaxes the borrowing constraints by potentially dampening the effects of financial frictions. Thus, our results provide some support for the widespread use of macroprudential policy in emerging market economies. Other contributions in this book provide theoretical and empirical evidence on the efficacy of macroprudential tools in affecting the response of financial conditions to various shocks.
Our results also add to the literature on the asymmetric transmission of mac-roeconomic shocks—namely, that of monetary policy. Other studies have found that the intensity of monetary policy transmission is state-contingent, at least in advanced economies (Tenreyro and Thwaites 2016; Angrist, Jordà, and Kuersteiner 2018). Those studies suggest a role for durable goods in increasing or dampening the transmission of monetary policy shocks. If anything, the role for durables should be larger in emerging economies, as financial frictions are more important (for example, see Álvarez-Parra, Brandão-Marques, and Toledo 2013). Investigating the contribution of the exchange rate channel to a state-contingent transmission of monetary policy is an important task that we leave for future research.
Annex 7.1.
Countries in Sample
Countries in Sample
| Advanced Economies | Emerging Markets |
|---|---|
| Australia | Argentina |
| Austria | Brazil |
| Belgium | Chile |
| Canada | China |
| Czech Republic | Colombia |
| Denmark | Hungary |
| Estonia | India |
| Finland | Indonesia |
| France | Malaysia |
| Germany | Mexico |
| Iceland | Moldova |
| Ireland | Peru |
| Israel | Philippines |
| Italy | Poland |
| Japan | Romania |
| Korea | Russia |
| Latvia | South Africa |
| Lithuania | Thailand |
| Malta | Türkiye |
| The Netherlands | Ukraine |
| New Zealand | |
| Norway | |
| Portugal | |
| Slovak Republic | |
| Slovenia | |
| Spain | |
| Sweden | |
| Switzerland | |
| Taiwan Province of China | |
| United Kingdom |
Countries in Sample
| Advanced Economies | Emerging Markets |
|---|---|
| Australia | Argentina |
| Austria | Brazil |
| Belgium | Chile |
| Canada | China |
| Czech Republic | Colombia |
| Denmark | Hungary |
| Estonia | India |
| Finland | Indonesia |
| France | Malaysia |
| Germany | Mexico |
| Iceland | Moldova |
| Ireland | Peru |
| Israel | Philippines |
| Italy | Poland |
| Japan | Romania |
| Korea | Russia |
| Latvia | South Africa |
| Lithuania | Thailand |
| Malta | Türkiye |
| The Netherlands | Ukraine |
| New Zealand | |
| Norway | |
| Portugal | |
| Slovak Republic | |
| Slovenia | |
| Spain | |
| Sweden | |
| Switzerland | |
| Taiwan Province of China | |
| United Kingdom |
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There is reason to believe that the policy dilemma faced by emerging market central banks is different than what Rey discusses in the sense that they are not indifferent between exchange rate regimes and tend to choose regimes with some degree of exchange rate flexibility (see Vegh and others 2017).
The main advantage of local projections is the flexibility for tracing the dynamic response of variables to a shock compared to standard vector autoregression models. Compared to these models, local projections do not involve any nonlinear transformation of the estimated slope coefficients to obtain impulse responses, with the coefficients allowed to vary across horizons of the impulse response function.
Related to this finding, Vegh and others (2017) show that for the typical emerging market economy, inflation and output tend to move in opposite directions following a terms of trade shock. When the terms of trade shock is negative, output falls, inflation rises, net capital flows decline, and the nominal exchange rate depreciates. However, they do not investigate (but assume) the mechanism behind such co-movement like we do.
The rolling four-quarters-ahead expectations are a moving average of same-year and year-ahead expectations.
In addition, because our N is moderately large, the results of Phillips and Moon (1999) concerning nonspurious regressions and the normality of pooled estimators with nonstationary variables apply.
We prefer to use the two-day window to ensure that exchange rate responses to policy news are not affected by time-zone differences. We also tried Jarociński and Karadi’s (2020) monetary policy shocks as instruments for exchange rate changes, but the specification does not pass exclusion restriction tests.
See Kalemli-Ozcan, Liu, and Shim (2021) for a useful discussion.
