Exchange Rate Pass-through to Consumer Prices in Ethiopia: A VAR Approach

Abstract

Ethiopia's currency has experienced a prolonged devaluation in tandem with the high and
continuing inflation rate of the nation. In keeping with this, this article aims to investigate how
much the exchange rate affects consumer pricing. The study uses monthly time series data
spanning from January 2011 to December 2019 and the vector autoregression model. By using
impulse responses, the study found that the exchange rate pass-through to consumer prices was
lower than the exchange rate pass-through to import prices. The exchange rate pass-through to
consumer prices is found to be around 0.17% in the first year and then reduces to 0.14% in the
second year. The figures for import prices were 1.19% and 1.725%, respectively. Moreover, the
study using the forecasting error variance decomposition analysis showed that there are other
factors, such as price expectations, that explain inflation better than the exchange rate. The study,
therefore, concludes that the National Bank of Ethiopia need not be concerned about inflation
when devaluing the currency. Nonetheless, this does not mean the National Bank of Ethiopia
should devalue the currency, as this would still cause problems with the trade balance. The
National Bank of Ethiopia can pursue an independent monetary policy and an inflation-targeting
regime with relative ease