Does Economic Policy Uncertainty Confound Exchange Rate Pass-through to Domestic Prices in India?

Abstract

We examine the influence of economic policy uncertainty (EPU) on the degree of exchange rate pass-through (ERPT) to domestic prices in India. By analysing data on the nominal effective exchange rate (NEER) from 2003 to 2024, we estimate ERPT to both the consumer price index and the wholesale price index. Employing the autoregressive distributed lag (ARDL) model, while we find that an appreciation of NEER leads to reduction in prices, but on the contrary, with the increase in EPU, it leads to an increase in prices. The non-linear-ARDL estimation reveals an asymmetric ERPT effect with NEER appreciation showing relatively a stronger ERPT effect than depreciation, while both large and small exchange rate changes exhibiting similar pass-through effect on prices. Additionally, employing time-varying parameter vector autoregressions (TVP-VAR) technique, we find that except for four-quarter horizon, the impulse responses for one-, eight- and twelve-quarter horizons of prices to exchange rate shocks remain negative all throughout the period. Moreover, we find that ERPT to domestic prices is similar across optimistic, pessimistic and normal economic outlooks. Our findings emphasise the significance of EPU in influencing ERPT to domestic prices in India, highlighting the imperative for monetary authorities in emerging market economies to consider the role of EPU in the transmission mechanism of exchange rate movements to domestic prices.

JEL Codes: E31, F31, C22

Keywords

Economic policy uncertainty exchange rate pass-through inflation ARDL NARDL TVP-VAR India

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