Exchange rate pass-through in a regime-changing framework: Evidence from India

Abstract

Exchange rate dynamics constitute a fundamental channel through which macroeconomic policies transmit their effects, with fluctuations being determined not just by direct policy interventions but also by structural factors including relative price movements (Cheikh and Louhichi, 2016; M. P. Taylor, 2006), dominant currency pricing practices (Gopinath, Boz, et al., 2020), and cross-country interest rate differentials (Aron et al., 2014). These complex interactions generate several economically significant phenomena, most notably strategic complementarities in pricing behavior among firms (Mallick and Marques, 2008) and heterogeneous degrees of exchange rate pass-through (ERPT) across sectors and countries (Pinelopi Koujianou Goldberg and Michael M Knetter, 1997). Building on John B Taylor (2000)’s seminal hypothesis that credible low-inflationary regimes can substantially moderate ERPT by anchoring inflation expectations and reducing the frequency of price adjustments, this study provides a focused examination of India’s experience following its 2016 transition towards flexible inflation-targeting (FIT) framework. Our analysis seeks to determine whether this institutional shift toward a rules-based, transparent monetary policy regime has indeed contributed to lower pass-through elasticities by altering inflation persistence patterns and modifying firms’ pricing strategies (Bailliu, Bouakez, et al., 2004; Michael B Devereux and Engel, 2001). The Indian case offers particularly valuable insights given the country’s status as a large, structurally complex emerging market economy that has experienced significant exchange rate volatility while implementing inflation targeting. Our findings contribute to ongoing theoretical debates about the ERPT-monetary policy nexus, particularly regarding how institutional frameworks shape price dynamics. The study also yields practical policy lessons for other inflation-targeting emerging markets confronting similar challenges of managing external shocks and maintaining price stability amid global financial uncertainty. This thesis investigates the dynamics of ERPT and its implications for monetary policy in India’s under its inflation-targeting regime. Specifically, the study delves into four broad perspectives to unpack ERPT’s complexities: First, we examine monetary policy efficiency under FIT, identifying optimal policy rules for macroeconomic stability while analyzing ERPT during policy transitions through a structural macroeconomic model. Second, employing a Markov-switching framework, we assess asymmetric ERPT across pre and post-inflation targeting periods, revealing regime-dependent pass-through effects. Third, we investigate how terms of trade and monetary policy type jointly determine ERPT degrees, analyzing the interaction between external shocks and domestic policy frameworks. Finally, we explore how market structure, characterized by varying pricing power, market imperfections, and exogenous interventions, shapes ERPT patterns while linking exchange rate movements to demand elasticities. Through this multidimensional approach, the study provides policy-relevant insights for enhancing monetary policy effectiveness in emerging markets, with particular emphasis on managing exchange rate dynamics within India’s macroeconomic stabilization framework.