Exchange rates, prices, monetary policy and competitiveness

(article for the September Economic Review)

The impact of exchange rate fluctuations on prices and competitiveness is an important element to take into consideration in the monetary policy decision-making process. In this context, it is essential to quantify these effects and understand the channels they operate through. It is even more critical given that the European economies international environment has been subject to numerous changes over the last two decades, with the emergence of Economic and Union Monetary, the enlargement process and deeper European integration as well as globalisation of production processes and the greater exposure of developed economies to international trade. The research work presented in this article points up that the relationships between exchange rates and prices, on the one hand, and competitiveness and growth, on the other hand, depend heavily on the structural characteristics of economies, as well as on the economic shocks behind movements on the currency market.

A depreciation triggers inflationary pressure due to the rise in the price of imported goods that it causes. But why is the short-term sensitivity of prices to exchange rate fluctuations diminishing so sharply right across the price chain? Starting off relatively high and contemporary at the border, it becomes weak and deferred when it passes through to final consumer prices. There is little change in this finding between EU countries, even though they have very different degrees of openness. The weak transmission to consumer prices also varies little over time, even though the developed economies are becoming more and more open to imports. Trade in intermediate goods and the predominant share it accounts for in international trade flows helps to explain this deferred effect. The import price of intermediate goods, strongly affected by the exchange rate, only affects final prices indirectly by making up one of the elements of resident firms’ marginal cost. The global nominal rigidity throughout the domestic productive system up to the end user is the result of a build-up of delays in adjusting prices at the level of each stage in the production chain. The exchange rate effect is therefore slowed down considerably before feeding through to final prices.

The nature of the shocks that affect the economy also play a key role in the intensity of the exchange rate/consumer price relationship. An expansionary, inflationary monetary policy shock will thus trigger a depreciation of the domestic currency that reinforces the inflationary effect. Prices and exchange rates thus appear to be closely correlated. By contrast, a positive productivity shock pushes down domestic producer prices, to which the central bank reacts by cutting its key policy rate that in turn leads to a depreciation. The imported inflation in this case is dominated by the deflationary effect of the initial shock: prices and exchange rates are then decorrelated.      

Because it makes the goods produced by resident firms more competitive than those of their foreign rivals, a depreciation is assumed to have a stimulating effect on the economic activity of an economy via an improvement of its trade balance. However, the transmission of exchange rate movements to export prices may also be affected by international trade in intermediate goods. The growing specialisation and underlying development of global value chains may have reduced global substitutability between foreign and domestic goods and services, at least in the short and medium term. These elements weaken the link between price competitiveness and domestic and foreign demand for domestic goods and services, and may therefore mitigate the fact that a devaluation supports economic growth.

These observations are pertinent for monetary policy, which cares about price stability and consequently reacts to price changes that come from unexpected movements in the relative value of currencies. But the monetary policy reaction to inflation also affects exchange rate dynamics via economic agents’ expectations in uncovered interest rate parities. The more aggressively the monetary authorities react to deviations from the inflation target, the less final prices are affected by exchange rate shocks.