Risk premium shocks, monetary policy and exchange rate pass-through in small, open countries

The central banks of small, open countries often face the problem that the exchange rate of their currency appreciates or depreciates in response to impacts of external origin. Since, over time, these fluctuations are also reflected in consumer prices, inflation may depart from the optimal level. In my paper I study the way in which monetary policy and consumer prices respond to exchange rate fluctuations of external origin in the Czech Republic, the United Kingdom, Canada, Poland, Hungary and Sweden. Based on my estimates, I conclude that under normal circumstances a temporarily more aggressive interest policy alone does not help cushion shocks, and that the sensitivity of domestic prices to the exchange rate is similar in these countries irrespective of the interest rate policy they adopt. By contrast, price stability and the fact that inflation expectations are firmly anchored may reduce exchange rate pass-through considerably, which, in terms of inflation, offers better protection against external shocks. However, the results are not valid under circumstances where the central bank is experiencing severe market disturbances or panicky behaviour; firm interest measures in these cases may be appropriate and serve the intended purpose.