RMB Exchange Rate Incomplete Pass-through Effect To Inflation In China

The domestic price level has been rising since2006. The level of inflationmeasured by the consumer price index (CPI) had a year-on-year growth of8.7%inFebruary2008, which is the highest level in recent years. Many experts and scholarshave pointed out that the most effective measure to alleviate the problem of inflation inChina is RMB appreciation. The theory of appreciation to suppress inflation seemsvery reasonable. According to classic economic theory: The currency appreciation,usually leads to the relative prices decline of imported goods and the relative pricesincrease of export commodities, which leads to increased imports and reduced exports.Then the level of domestic inflation declines by pathway of money wage mechanismand the cost of production mechanism. On the contrary, the devaluation of the localcurrency often accelerates a country’s inflation situation.But the reality of our economy shows an opposite situation: At the same time of amore substantial appreciation, the level of inflation does not decline, but shows a risingtrend. In fact, the nominal effective exchange rate has a considerable increase since thereform of the exchange rate system in July,2005. In the end of October2012, itscumulative appreciation had been over20%. At the same time, the trend of inflationlevel did not significantly decrease but rise, and repeatedly hit record in history. In2007, China’s CPI rose4.8%, and in the first half of2008, CPI rose7.9%. CPIcumulative increase was26.31%(in the end of October2012) since the exchange ratereform. RMB exchange rate and the CPI were in the same direction. The reality goesagainst the classical economic theory. The sharp appreciation of the RMB has notbrought a corresponding decline in the level of inflation. What are the reasons? CanRMB appreciation effectively suppress inflation? What extent to ease inflationarypressures by appreciation of the RMB? These issues become the focus of the academiaand the policy authorities.For conventional macroeconomics based on “the law of one price”, the change ofthe price should be in the same proportion to the change of exchange rate.But in reallife, the exchange rate change does not bring the same change proportion of the price level because of the imperfect competition market, sunk cost and the commodity pricestickiness and other reasons. In another word, the exchange rate pass-throughcoefficient is not equal to1. This phenomenon in economics research is calledexchange rate "incomplete pass-through effect". This paper attempts to make areasonable analysis and interpretation on why RMB appreciation fails to effectivelycurb inflation from the view of the exchange rate incomplete pass-through effect. Theimport trade occupies a very important position in the national economy, and importdependence is very high. Lack of international commodity pricing power,the elasticityof demand for imported goods and continued trade surplus and large inflows of hotmoney bring the RMB exchange rate incomplete pass-through, which leads to policiesfailure to curb inflation through RMB appreciation.This paper focuses on the study of China’s monetary policy operations under thecondition of RMB exchange rate incomplete pass-through effect. It describes thetheory of exchange rate pass-through effect and its transmission mechanism, andanalyzes the theory of incomplete exchange rate pass-through effect and its influencingfactors and the impact on the domestic economy. Then we use cointegration test andvector auto regression (VAR) model testing the RMB incomplete exchange ratepass-through effect. By cointegration test, we find that: in a long term, it has acointegration relationship between the consumer price index and the nominal effectiveexchange rate of RMB.VAR model tells us that exchange rate changes have a negativeimpact on IPI and CPI in a short term. However, RMB appreciation cannot suppresslevel of inflation. What is more, we analyses the reason of RMB exchange rateincomplete pass-through effect and its impact to economy in China. Finally, the paperproposes measures of policy operations in China based on the conclusion of the RMBexchange rate incomplete pass-through.RMB appreciation which fails to effectivelycurb inflation is not an effective means to controlling inflation; Central Bank should bereasonable to adjust monetary policy and strengthen the control of inflation.