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Exchange rate pass through, cost channel to monetary policy transmission, adaptive learning, and the price puzzle

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  • Ali, Syed Zahid
  • Anwar, Sajid

Abstract

Using a New Keynesian open economy model, where the supply side effects of the exchange rate pass through as well as the cost channel of monetary policy transmission are taken into account, this paper evaluates the possibility of the price puzzle, which refers to anomalous behavior of inflation to a monetary shock. Unlike the existing studies, we consider the possibility of the price puzzle when agent expectations are based on adaptive learning and three monetary policy alternatives (the optimal monetary policy, money growth targeting, and a Calvo-type policy rule) are available to the central bank. Furthermore, we use two alternative measures of inflation. Calibration of our medium scale model, using plausible parameter values, reveals that irrespective of how the inflation rate is measured and the policy rule used by the central bank, the puzzle fades away when a sufficiently strong exchange rate pass through is present in the economy. We also find that a decrease in inflation is associated with a cost to the society in the form of lower aggregate output but this loss is minimum when the central bank uses the optimal monetary policy.

Suggested Citation

  • Ali, Syed Zahid & Anwar, Sajid, 2017. "Exchange rate pass through, cost channel to monetary policy transmission, adaptive learning, and the price puzzle," International Review of Economics & Finance, Elsevier, vol. 48(C), pages 69-82.
    • Handle: RePEc:eee:reveco:v:48:y:2017:i:c:p:69-82
    DOI: 10.1016/j.iref.2016.11.010
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    More about this item

    Keywords

    Learning; Exchange rate pass through; Price puzzle; Cost channel; Calvo rule; Optimal monetary policy;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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