Research On The Effect Of RMB Exchange Rate Pass-through On Domestic Prices In China

Prices and exchange rate, the two core economic variables in an open economy, are closely related with each other, which have a significant effect on economic activities. On July 21^st, 2005, RMB exchange rate against US dollar appreciated by 2%. Since then, China started to reform the exchange rate regime by moving into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. RMB exchange rate regime has been improved with greater flexibility. Meanwhile, China's consumer prices rise continuously. This paper investigates the effect of RMB exchange rate pass-through on domestic prices in China. First, the paper summarizes the main pass-through theories, and observes the fluctuations of RMB exchange rate and China's CPI from 1994 to 2008. Then we conduct an empirical study by means of co-integration and vector error correction model, using monthly data from January 2001 to December 2008. The results show all the six variables are co-integrated in the long run, while the effect of RMB exchange rate pass-through on China's CPI is weak. The major factors that influence China's CPI include CPI itself, corporate goods price index (CGPI), and money supply.