Exchange Rate Pass-Through in a Small Open Economy: A Structural VAR Approach

Pass through from the exchange rate developments to consumer prices could be an important dimension of inflationary dynamics in small open economies. In such economies, the proper identification of exchange rate pass through (ERPT) is crucial for monetary policy analysis. In this paper, we study ERPT in Turkey for the period of 2006m1-2015m6, which starts with the launch of explicit inflation-targeting regime. We first show that commonly used recursive VAR model generates unrealistic dynamics like effects of domestic variables on external variables in small open economies and as result ERPT estimate is biased. This bias comes from the unrealistic decline in energy prices in response to depreciation of currency for the given period in Turkey. We then use a structural VAR model with block exogeneity assumption. This model generates more realistic dynamics and suggests that ERPT is around 18 percent in Turkey. Overall, the analysis demonstrates the importance of using realistic model setup and checking the relationships across variables when estimating ERPT in small open economies.