Author
Mehak EJAZ* and Qadeer KHALID**
Abstract
This study explores the pass-through of unanticipated movements in growth and variance of exchange rate to inflation. First, it quantifies the volatility of the exchange rate by using the GARCH-X model. Foreign exchange reserves are considered as an exogenous variable that plays an instrumental role in stabilising the exchange rate. Second, the SVAR model is estimated to identify the responses of inflation to unanticipated shocks. The results indicate that there is a direct relationship between exchange rate volatility and inflation in the economies where the volatility is relatively high, such as Pakistan, India, Indonesia, the Philippines, and Turkiye. In contrast, in economies with flexible exchange rate regimes and less volatile exchange rates, volatility tend to have either a negative or minimal effect on inflation. The findings on the effect of unexpected exchange rate fluctuations on inflation align with economic theory. Countries like Pakistan, India, Indonesia, Malaysia, Hungary, Egypt, Georgia, and Poland, which experience greater exchange rate volatility, exhibit a positive pass-through to inflation. Consequently, the paper concludes that exchange rate stability is crucial for controlling inflation in emerging economies. Additionally, the study suggests that these countries should prioritize building adequate foreign exchange reserves, and emphasizes the importance of central bank independence in monetary policy decision-making.
