Exchange Rate Transmission into Sectoral Consumer Price Inflation in Ethiopia: SVAR Approach

Abstract: This paper employs recursive structural vector autoregression (SVAR) to study exchange rate pass-through into domestic consumer price inflation in Ethiopia. The study utilizes quarterly data spanning out the period from 1997.3 to 2011.4. Innovation accounting from the resulting SVAR was performed to trace out the impact of a one-time unit shock in one variable on the trajectory of other variables over time. The impulse response function analysis indicates that nominal effective exchange rate plays an important but shortlived role in affecting consumer price developments in Ethiopia. In particular, a unit change in the trade weigheted exchange rate (appreciation) caused the consumer price inflation to fall by about 0.01 after four quarters (or an accumulated response of about 0.11after 14 quarters). As a result, exchange rate pass-through into domestic prices in Ethiopia is incomplete and inconsequential. The forecast error variance decomposition exercise shows own shock explains about 63 percent of the forecast error variability of inflation followed by world oil price (20 percent) and exchange rate (13 percent). Monetary aggregate has triavial effect for all horizons considered.Regarding the components of CPI, sectors which have higher import content exihibit relatively stronger pass-through effects.