Consumer Price Inflation and Exchange Rate Pass-Through in Jamaica - Literature review Example

Consumer Price Inflation and Exchange Rate Pass-Through in Jamaica The current research study attempts to determine the impact of Exchange Rate Pass-Through and the influence of inflation on the economic growth and development of Jamaica. With this objective, a brief literature review regarding the topic has been conducted, with the help of data retrieved from relevant and authentic secondary sources such as scholarly journals, peer-reviewed articles and reports. For analyzing the gathered data, qualitative data analysis was used that helped in deriving a valid conclusion regarding the subject matter. Results derived thus from analysis, reveal those alterations in the exchange rate, which leads to inflation on the Jamaican economy. Correspondingly, the minimization of exchange rate would lower inflation that would significantly be beneficial for the economic development of the country. Consumer Price Inflation and Exchange Rate Pass-Through in Jamaica The economic growth and development of a country is completely dependent on Consumer Price Inflation and the Exchange Rate Pass-Through (ERPT) of that particular nation (Farlane, 2009). High rate of inflation has been a major challenge for the countries, as it negatively affects monetary policy formulated by the nation’s government, which correspondingly affects its economic development at a larger context. To put it briefly, ERPT is generally referred to a measure to understand the responsiveness of international prices for the alterations in exchange rates (Choudhri & Hakura, 2012). It is therefore the percentage change in domestic currency of import costs, which results from 1% exchange rate change between the importing and exporting countries. Moreover, alterations in the import prices influence the consumer prices and retail prices as well. It is generally notable that when ERPT is high, the diffusion of inflation between the two countries is also high. However, it is eminent that the Consumer Price Inflation is affected by ERTP, which has become a major issue for the government of certain countries, such as Jamaica (Zorzi, Hahn & Sanchez, 2007). Contextually, the objective of this paper is to understand ERTP and the extent to which exchange rates are responsible for the alteration of relative prices. The paper is divided into overall six sections, which progresses through literature studies and discussions on the trends of inflation and exchange rates in Jamaica. Moreover, the study is conducted by analyzing the secondary data collected through reliable research articles, which in turn has been tested in view to support in drawing effective conclusions. Literature Review According to Bussière & Peltonen (2008), ERPT usually refers to the percentage change in the import prices of local currency that result from 1% change in the exchange rate between the imports and the exports of countries. There are two major channels of ERPT, including direct and indirect channels, which are quite important for an open economy (Devereux & Yetman, 2008). In addition to these two channels there is another major channel through ‘expectations’, according to which, the changes in exchange rates are assumed to be reluctant and thus, the adjustment of prices are made as per the expectations of people living in the particular country. It is in this context that the purchasing power parity and the ‘law of one price’ increase the significance of direct channel. Bussière & Peltonen (2008) has referred the relative version of purchasing power parity, which explains that potential exchange rate between the currencies of two countries is determined by the alterations of price levels of the countries. This includes the change in exchange rates that influence import prices and thus, subsequently increases the domestic prices. This can be represented in the form of P = E ● P* where, ‘P’ signifies the cost of importing goods in terms of domestic currency, ‘E’ represents the rate of exchange in terms of domestic currency based on one unit of foreign currency and ‘P*’ implying the imported good’s price in terms of foreign currency (Farlane, 2009). In this case, the pass-through is considered to be completed only if there is a fixed marginal cost as well as a fixed mark-up of prices over costs. However, the transmission mechanism of ERTP can be demonstrated with the help of the following flow chart. Transmission Mechanism of Exchange Rate Pass Through As a result of the influence on aggregate demand, the indirect channel of ERPT arises while the depreciation is imposed on exchange rates lead to cheaper domestic products available for foreign customers (Zorzi, Hahn & Sánchez, 2007). Thus, the aggregate demand and exports will rise, thereby increasing the domestic price level, which would serve beneficial for the domestic country. Devereux & Yetman (2010) has also stated that as there is a fixed nominal wage in short run, wherein the real wages decrease and correspondingly, the overall output increases, but if the real wages increase the overall production cost also increases, which would result in the decline of the overall output level. Therefore, the ‘Exchange rate depreciation’ permanently increases the price level. Nevertheless, it must be noted that with a temporary increase in the overall output, the economic growth of the country might get affected. However, according to Bailliu & Bouakez (2004) there were two major factors including the size and the openness of the economy, which could further influence the level of pass-through. In addition, some other factors having an influence on the company may include micro-economic conditions, macro-economic conditions, traded goods supply and relative elasticity of demand. In case of imports, there will be an increase in the degree of pass-through if elasticity of demand is lower and the elasticity of supply is higher. Whereas, on the other hand, in case of exports, higher elasticity of demand and lower elasticity of supply will lead to an increased level of pass-through (Devereux & Yetman, 2010). This suggests that pass-through for a small open economy will be completed where the exporters will be experiencing perfect elasticity of demand and the importers from foreign countries will witness a perfect elasticity of supply. Therefore, in the global market, the country would be the price taker, which will help it gaining a significant position in the world economy (Zorzi, Hahn & Sánchez, 2007). However, according to Farlane (2009), there are various reasons for the low pass-through generally represented by ‘pricing to market’ and imperfect competition between the countries. In this regard, when similar types of products are traded in the world market, price differentials between the commodities are eliminated due to arbitrage (Bailliu & Bouakez, 2004). Conversely, when the markets are segmented and imperfectly competitive there is high scope of pricing responses. Zorzi, Hahn & Sánchez (2007) thus stated that the level of pass-through varies from country to country, which implies that alterations in the exchange rates do not require the substitution of international goods and domestic goods. This is because of the absence of vast differences between the prices to be paid by the consumers for their products. Through the empirical study conducted by Bailliu & Bouakez (2004), it is eminent that exchange rate pass-through to consumer price is generally modest in majority of the industrialized economies. The changes in exchange rates and the share of imports in a country is therefore observed as positively correlated with the degree of ‘pass-through to consumer prices’ whereas, there exists a negative correlation with the volatility of exchange rates. For countries having constant exchange rates and with higher share for domestic import, the degree of pass-through is also considered higher for those economies (Devereux & Yetman, 2008). Hence, it can be argued that making the import share of a country a substitute for import penetrations being experienced by the companies will lead to a higher exchange rate pass-through along with the fluctuations of import prices that will benefit the domestic country (Farlane, 2009). Trends of Inflation and Exchange Rates in Jamaica Jamaica possesses a small and open economy and for monetary policy, wherein the exchange rate serves as a major transmission channel apart from the aggregate standard demand channel (Farlane, 2009). The term ERTP generally signifies the impact of exchange rates on any one of the following that includes consumer prices, export and import prices, trade volumes and investments. However, among these factors, the current study focuses on the manner through which, the consumer prices are being influenced by exchange rates (Bailliu & Bouakez, 2004). For the government of Jamaica, it is very essential thus to consider ERPT to consumer prices for the formulation of exchange rate policies as well as monetary policies. It is also notable that lower ERPT value provides enhanced opportunity for a country to facilitate inflation and thereby, targeting and adopting a self-governing monetary policy. From recent studies on the economy of Jamaica, it is also eminent that there has been a rapid fall in inflation and the growth of monetary supply has also reduced during the previous five years. Thus, the competitiveness of the economy has increased substantially that has led to a gradual shift in the ERPT (Choudhri & Hakura, 2012). Considering the annual inflation rate of Jamaica for the past few years, it is prominent that the inflation rate is moderate in the country. The inflation rate of Jamaica recorded on April 2015 was 4.04 percent, which is evaluated as considerably lower as compared to the previous years (2Trading Economics, 2015). In between the years from 2002 to 2015, the inflation rate in Jamaica was recorded at an average of 10.63 percent. However, the highest ever-rated inflation rate was recorded in the month of August 2008 that was 26.49 percent, while the lowest inflation rate of the country was recorded at 4 percent on March 2015 (2Trading Economics, 2015). Therefore, considering the trend of inflation in the past few years, it is prominent that the inflation rate of Jamaica is on a downward trend, which is beneficial for its economic growth and development. Similarly, the exchange rate of Jamaican dollar is also exhibiting an increasing trend, which signifies a positive impact on the country’s economy. The Jamaican dollar, with respect to the US dollar, increased from 115.27 in April 2015 to 115.96 in May 2015 (1Trading Economics, 2015). However, during the period of 2004-2015, the Jamaican dollar was rated at an average of 82.24. The highest recorded value of Jamaican dollar was 115.96 that were recorded in the present year, with its lowest recorded value as 59.80 in the year of 2004 (1Trading Economics, 2015). Therefore, it is also eminent that during the course of time, there have been substantial improvements in the inflation rate of the country along with its exchange rate, which aided the country to gain a significant position within the global economy. Research Methodology Data Collection Data collection methods are generally segregated into two categories that include the primary data collection method and the secondary data collection method. Selection of the most appropriate data collection method depends on the type of research study along with the convenience and authenticity of data sources (Institute for Work & Health, 2009). In this research study, relating to consumer price inflation and exchange rate pass-through, only secondary data collection method has been considered in order to acquire reliable and authentic data. Some major advantages of using secondary data collection are its hustle free nature and availability of adequate data in relevance to the subject matter. Moreover, collection of secondary data consumes lesser time and is less expensive in comparison to the primary data collection method. In context to the given research study, it would serve difficult to conduct primary research because of the limited time available and collecting primary data from government officials, which would be a lengthy process. Primary data from various secondary sources, including government reports, articles and journals, have been collected for analysis in order to strengthen the data collection procedure. Moreover, literature review has been conducted from various authentic secondary sources that ensure relevant information relating to the subject matter. Therefore, corresponding analyzing of such data would provide a reliable outcome to the research study. Data Analysis Method Data analysis is one of the most essential sections of a research study, as it involves the analysis of primary and secondary data, which are retrieved for the research study with the help of various tools and techniques. In context to the given research study, qualitative method of data analysis have been used in order to conduct the overall research in an in-depth manner (WebMD LLC, 2015). Data analysis therefore plays a major role in ascertaining the relevancy of data being collected by inspecting every component of the data. It is generally the process of converting the raw data into information, which supports in the decision-making and effective conduct of the overall research study. The secondary data collected for the research study has thus been analyzed comprehensively and carefully in order to understand ERTP and the extent to which exchange rates are responsible for the alteration of relative prices in Jamaica. Therefore, the prime aim of data analysis is to summarize the entire research and reveal the important features essential for the improvement of the subject matter concerned in the research (Community Tool Box, 2014). In the current research study, the descriptive research analysis has been used that would support in gaining an in-depth understanding about the subject matter. Ethical Considerations of the Study While conducting any research study it is very essential to consider ethical values that may increase its reliability and validity to a substantial extent. Even though considering the ethical means may sometimes create hindrances to the researcher in obtaining relevant and sensitive information regarding the subject matter, yet it is inherently necessary to follow the ethical values during the conduct of a research (National Institute of Environmental Health Sciences, 2013). Similarly, in the current context, all the ethical values have been considered to ensure that the secondary data are being collected from authentic and reliable sources that included scholarly journals, peer-reviewed articles and governmental reports. Moreover, the current study also attempted to reduce biasness during the data collection process that had a corresponding effect on the data analysis process. It was also ensured that the data has been collected from appropriate sources that are relevant to Jamaica. Limitations of the Research Study One of the major limitations of the research study is that primary data collection method has not been applied for the collection of data. Collecting data from primary sources, such as conducting interview surveys would serve beneficial in gathering more information relating to the subject matter. In addition, another limitation of this study was its lack of focus on quantitative data analysis that would have provided with greater statistical interpretation. Findings and Analysis Analyzing the literature review, it is notable that the economic system of Jamaica is becoming stable with the course of time that signifies a positive response for the economic growth and development of the country. The inflation rate of the Jamaican economy has been falling significantly over years, which is a positive indication for the country. The present inflation rate of the country has also been recorded at 4.40 percent as compared to 26.49 percent that was recorded in the year 2008 (2Trading Economics, 2015). This represents that there has been a significant improvement in the inflation rates in the country. Stating precisely, lower rate of inflation led to the increase in exchange rates of the country, which ultimately influenced the prices of its domestic products. The rate of Jamaican dollar is also increasing gradually that resulted to the profitable imports in the country through which, the people of the country have been considerably benefited (2Trading Economics, 2015). The degrees of pass-through of a country are generally influenced by the openness as well as the size of the economy. Jamaica has an open economy and therefore, the pass-through of the country depends on the rate of its inflation. Notably, inflation rate trend is directly correlated with the variations in the rate of exchange (Choudhri & Hakura, 2012). From the introduction of exchange rate regime in the year 1990, the exchange rate is determined based on market situation. During the period, it was found that there was a high depreciation of the Jamaican currency against the US dollar. This occurred particularly because of the increased inflation rate in the country (Devereux & Yetman, 2008). However, with the gradual progression of time, the inflation rate started decreasing and thus, the value of Jamaican currency increased considerably, which was a positive aspect for the economy overall. It is therefore quite essential for Jamaica to possess a stable ERPT, as the monetary policy formulated by the government completely depends on it. The country has also been experiencing lower inflation rate from the latter half of 1995 that has resulted into the increased competition among the domestic and foreign economies (Farlane, 2009). It shall thus be beneficial for the country to possess an equilibrium exchange rate, as the change in its exchange rate would possibly result in a greater domestic price. Depreciation in the exchange rates may also result in selling the domestic products to the foreign customers at a cheaper rate that would negatively affect the economy of Jamaica and vice-versa (Bailliu & Bouakez, 2004). Conclusions From the overall discussion, it can be concluded that ERPT of Jamaica highly affects the economic performance of the overall country. Contextually, the findings of the study revealed that the exchange rate of the country is one of the most important factors that have led to inflation and therefore, it is considered feasible for the country to lower the exchange rate that would serve beneficial for its economic development. Discussions have also been provided in this research study concerning the impacts of changing exchange rates on consumer price inflation. From the analysis, it is eminent that the rate of inflation in Jamaica has been at a decreasing trend, which resulted with an increasing exchange rate. Moreover, the degree of pass-through has also been sloping downwards that has only become possible because of the effective monetary policy, structural transformation and decreasing private demand practiced in the country’s economy. The exchange rate regimes being implemented in the country, along with the alterations of exchange rates, are the major factors that affect the pass-through. In addition, the alteration in the exchange rates in the country is also a major factor that influences the pass-through in Jamaica, which ultimately affects the economic development of the country. However, from the literature review, it can be found that pass through and exchange rates are contradictory to each other. If the pass through is higher, the volatility of exchange rate is greater and vice versa. In the latter half of 1995, the high volatility of exchange rates resulted in declining the pass through in the country. High exchange rate leads to inflation, which is harmful for the economic growth of Jamaica. Thus, reducing the exchange and thereby lower the inflation that would ultimately serve beneficial for the economy in taking measures. References Bailliu, J. & Bouakez, H. (2004). Exchange rate pass-through in industrialized countries. Bank of Canada Review, 19-28. Bussière, M. & Peltonen, T. (2008). Exchange rate pass-through in the global economy the role of emerging market economies. European Central Bank, 1-45. Choudhri, E. U. & Hakura, D. S. (2012). The exchange rate pass-through to import and export prices: the role of nominal rigidities and currency choice. International Monetary Fund, 1-33. Community Tool Box. (2014). What do we mean by analyzing data? Retrieved from http://ctb.ku.edu/en/table-of-contents/evaluate/evaluate-community-interventions/collect-analyze-data/main Devereux, M. B. & Yetman, J. (2008). Price adjustment and exchange rate pass-through. Hong Kong Institute for Monetary Research. Devereux, M. B. & Yetman, J. (2010). Price-setting and exchange rate pass-through: theory and evidence. The Hong Kong Institute for Monetary Research, 347-371. Farlane, L. M. (2009). Time-varying exchange rate pass-through: An examination of four emerging market economies. Research and Economic Programming Division Bank of Jamaica, 1-28. Institute for Work & Health. (2009). What researchers mean by primary and secondary data. Retrieved from http://www.iwh.on.ca/wrmb/primary-data-and-secondary-data National Institute of Environmental Health Sciences. (2013). What is ethics in research & why is it important? Retrieved from http://www.niehs.nih.gov/research/resources/bioethics/whatis/ 1Trading Economics. (2015). Jamaican dollar. Retrieved from http://www.tradingeconomics.com/jamaica/currency 2Trading Economics. (2015). Jamaica inflation rate. Retrieved from http://www.tradingeconomics.com/jamaica/inflation-cpi WebMD LLC. (2015). Presenting and evaluating qualitative research. Retrieved from http://www.medscape.com/viewarticle/731165_3 Zorzi, M. C., Hahn, E. & Sánchez, M. (2007). Exchange rate pass-through in emerging markets. European Central Bank, 1-31. Read More