The Research Of RMB Exchange Rate Pass-Through Under Inflationary Environment

The exchange rate is a core tool variable in an open economy and plays an important role in adjusting a country’s internal and external balance. Since the exchange rate reform in 2005, the exchange rate of RMB has been in appreciation state. According to the traditional theory, exchange rate appreciation will reduce exports and increase imports, and then lower the price level. However, China has experienced three rounds inflation since 2003, the currency appreciation didn’t reduce the domestic price level. Therefore, this paper chooses the RMB exchange rate pass-through as the main object of study, then explores the relationship between exchange rate and inflation, the reasons for different pass-through effect occurs in different time and checks if the theory of "currency appreciation to curb inflation" is suited in China.By deriving the conditions of profit maximization based on the theory of staggered pricing and combing literature, this paper empirically analyze the RMB exchange rate pass-through. The empirical research is composed of two parts. The first part applies the smooth transition auto-regression model to investigate the transmission between exchange rate and price in China based on the theory model. Empirical study shows that both short-term and long-term exchange rate pass-through effect indicate that exchange rate appreciation could reduce domestic inflation in the period of low inflation. But in contrast, exchange rate appreciation will stimulate further increase the inflation. The critical value is 0.0115. The pro-cyclical effect of exchange rate appreciation on inflation indicates that monetary authorities should be careful to control exchange rate fluctuations so as not to push domestic prices to rise further.The second part analyses the main factors of inflation from monetary, demand and cost aspects, and then extracts three main factors based on the method of factor analysis. It seems that the demand factor and momentary factor are the main reasons of inflation, the effect of cost factor is weaker. To establish a more realistic exchange rate pass-through model, this part adds the main inflation factors into first part of the empirical analysis. The study finds that a lower inflation environment corresponds to a lower exchange rate pass-through effect and a higher inflation environment corresponds to a higher exchange rate pass-through effect. In times of low inflation, the linear part plays a major role and the appreciation of the RMB will reduce domestic inflation. In times of high inflation, the nonlinear part plays a major role, the appreciation of the RMB can’t ease domestic inflation but to aggravate inflation. When the inflation rate reaches 0.7636, the exchange rate pass-through effect will reach a critical state from low to high transition. Also the transition appears smoother. Therefore, the exchange rate pass-through effect is often related to the domestic inflation environment.There is no doubt to establish a more flexible exchange rate regime. In order to avoid great negative impact on the domestic economy, the monetary authorities should control domestic inflation so that the exchange rate pass-through effect can be controlled at a low level. Empirical results show that the theory of "currency appreciation to curb inflation" doesn’t hold up in China, the inflation management requires a variety of governances. In addition, the establishment of low and relatively stable inflation environment is benefited for trading parties to establish long-term cooperation. We must strive to create a favorable inflation environment to ensure the sound operation of the domestic economy.