Application Of Incomplete Exchange Rate Pass-Through In China

On July 21st, 2005, The people' s bank of China declared that RMB exchange rate aginst US dollar appreciated 2%, and RMB exchange rate regime was turned from pegging against US dollar to managed floating exchange rate regime based on market demand and supply and adjusted to a basket of foreign curreicies. From then on RMB exchange rate said good bye to more than ten years long fixed exchange rate regime and entered the era of managed floating exchange rate regime. In the past two years fluctuations of exchange rates have become a indispensable part of economy. With the increased expansion of exchange rate fluctuations, whether this will affect the stability of domestic prices, and what monetary policies the central bank should take to deal with the unexpected impact of exchange rate fluctuations on policy aims, have attracted the attention of domestic economists to study the relationship between RMB exchange rates and prices at different levels.Based on summation on relevant theories, using data from Janruary 2000 to March 2007, this paper focuses on empirically study the effect of RMB exchange rate movement on domestic prices. Comparative analysis method is used to analyze the effect Of RMB exchange rate reform on RMB exchange rate pass through effects. The empirical results reveal that, import prices are most sensitive to movement of RMB exchange rate, next is corporate goods prices, and consumer prices are least sensitive to RMB exchange rate movement. After RMB exchange rate reform, the pass through effect of RMB exchange rate to import prices and coporate goods prices is less, while the pass through effect of RMB exchange rate to consumer prices is more. The structure of this article is organized as the following:The first chapter is an introduction. It is undoubted that exchange rate fluctuations will affect prices and cause different price indices to change correspondently to different extents. However, whether the exchange rate pass-through effect is complete or incomplete is indeterminate. To grasp the pass-through effects, the determinant factors and future movements has important economic and policy implications for the central bank which is responsible to control exchange rates and take appropriate monetary policies to offset the disturbation of exchange rate fluctuations on prices stability. This article aims to pin down the pass-through mechanism and effects of RMB exchange rates on different price indices and their determinants. So, this part introduces the concepts and mechanisms of exchange rate pass through and theories on incomplete exchange rate pass through. After pointing out the shortages and disadvantages in domestic relevant research, this paper proposes the innovations in this article.Chapter two is a summation on relevant research. Research interests in exchange rate pass through originated from the explanation for the invalidity of PPP theory in 1960s and 1970s. From 1980s the direction of research on exchange rate pass through turned to industrial organization, market segmentation and product differentiation. In 1990s many industrial countries experienced great depreciations of currencies, however their economic performances showed that the exchange rate pass through was in decline. This phenomenon promoted the economists to study the stability of exchange rate pass through and the reasons for the wide and persistent decline in the exchange rate pass through in these countries. Recent research focused on the relationship between exchange rate pass through and the validity of macroeconomic policies, and related the exchange rate pass through to the choice of optimal monetary policy and exchange rate regime. A great amount of empirical research on exchange rate pass through suggested the pass through of exchange rates to both import price and other general prices were incomplete, however the pass through effect to import price was larger than that to other general price indices. Economists tried to explain these conclusions from micro and macro aspects. Finanlly this chaper made a comment on domestic relevant research and pointed out the research focus and innovations in this article.Chapter three presents theoretical and empirical research on RMB exchange rate pass through to import prices. This part first analyzes the effect of change in RMB exchange rate on dometic import prices by virture of graphical analysis and mathematical deduction. Then econometric models are employed to further study the pass-through effect of RMB exchange rate to the general import price index and sub-group import prices by using relevant quarterly data from January 2000 to March 2007. The empirical tests reveal that the pass-through effects of RMB nominal effective exchange rate to the general import price are larger than one both in short term and in long term, which indicates that the exports abroad overreact to the fluctuations in RMB exchange rates. The reactions of sub-group import indices to exchange rate fluctuations have significant differences. The import prices of food, wheat and sugar are more sensitive to changes in RMB nominal effective exchange rate both in short term and in long term, and their price fluctuations are also more liable to exchange rate fluctuations. The import prices of raw materials, raw petroleum, rubber and log are less sensitive to exchange rate fluctuations and their price fluctuations are also less liable to exchange rate fluctuations.In chapter four this paper theoretically and empirically analyzes RMB exchange rate pass through to domestic general prices. This part first utilizes a classical model to delineate the effect of transportation costs, intermediate distribution costs and monetary policy on exchange rate pass through to general prices. Basd on theories this paper uses relevant quarterly date from January 2000 to March 2007 to test the pass-through effects of RMB nominal effective exchange rate to domestic general prices and further uses the sub-sample data to investigate the effect of RMB exchange rate formation reform on RMB exchange rate pass through. The empirical tests show that the change in RMB nominal effective exchange rate has significant negative effects on import price and corporate goods price both in short term and in long term, and furthermore the pass through of exchange rate fluctuations to import price is larger than that to corporate goods price. Nevertheless, after RMB exchange rate formation reform, both the pass-through effect of exchange rate to import price and that to corporate goods price have declined. The pass-through effect of RMB nominal effective exchange rate to consumer price is quite weak. The appreciation of RMB nominal effective exchange rate will first increase the consumer price and then decrease the consumer price. After the RMB exchanage rate formation reform, the reaction of consumer price to exchange rate fluctuations is lagged. However, in comparison to the effect before RMB exchange rate formation reform, the pass-through effect of exchange rate to the consumer price increases.Chapeter five is conclusions and policy recommendations. This part presents a summation on previous empirical results and recommends reliable explanations based on relevant theories and status quo in China. Relevant political implications are proposed toward those empirical conclusions.