RDP 9304: Exchange Rate Pass-Through: The Different Responses of Importers and Exporters 2. Trends in Exchange Rates and Prices

In Australia, since the mid 1970s, episodes of currency depreciation have tended to be accompanied by an increase in inflation.^[3] The experience of the last decade is illustrated in Figure 1. The value of the Australian dollar on a trade-weighted basis is represented by the trade-weighted index (TWI). The TWI is inverted, so that an increase in the index represents depreciation, and is plotted against the annual rate of inflation.

From Figure 1 it is clear that the initial episode of currency depreciation in the early 1980s was accompanied by an increase in inflation. The record depreciation of the mid 1980s was also accompanied by an increase in inflation, although one which was less than proportionate. Conversely, the latest episode of currency depreciation has coincided with a fall in inflation.

The progress towards our present environment of low inflation has resulted in each peak in inflation being less than its predecessor. Many factors, monetary and non-monetary, have contributed to the nation's present inflation performance (Stevens 1992). However, for the first time, a major episode of currency depreciation has not been directly manifested in inflationary pressure, or at least not yet.

The apparent absence of inflationary pressure is reinforced in Figure 2 where the percentage point contribution of retail import prices to annual inflation is illustrated.^[4]

During the previous major depreciation of the mid 1980s, a substantial share of the annual inflation rate was directly attributable to higher retail prices of imports.^[5] Conversely, during the recent depreciation, the retail prices of imported goods have not contributed to inflation.

Certainly, the world prices of Australia's imports have been subdued since 1989/90. Furthermore, the extent to which the collective forces of recession, wage restraint and microeconomic reform have offset the inflationary effects of depreciation is not known. In other words, the counterfactual is not known. Nonetheless, the impact of the recent depreciation on the general price level has been less than expected. Thus we commence with the testable proposition that price-setting agents have altered their responses to changes in the exchange rate. The framework for our analysis is outlined below.

Footnotes

Prior to this time inflation tended to be associated with international shocks. See Stevens (1992) for an analysis of the determinants of Australia's inflation performance for the period 1950 to 1991. [3]

Given the rural and resource based nature of the majority of Australia's exports, very few exportable prices are included in the CPI. Consequently, the inflationary impact of depreciation is largely captured by the contribution to changes in the CPI of items ‘wholly or predominantly imported’. [4]

Of course, currency depreciation also has an indirect effect on inflation (via the cost of imported inputs, inflationary expectations, wage outcomes, etc) which may be substantial and is not captured in Figure 2. [5]