Exchange Rates, Domestic Prices, and Central Bank Actions: Recent U.S. Experience

• Published in: Southern economic journal Vol. 64; no. 4; pp. 957 - 972
• Main Authors: Parsley, David C., Popper, Helen A.
• Format: Journal Article
• Language: English
• Published: Chapel Hill, N.C., etc Southern Economic Association 01-04-1998; Southern Economic Association and the University of North Carolina
• Subjects: Aggregates; Analysis; Central banks; Consumer Price Index; Currency devaluation; Domestic markets; Economic aspects; Economic policy; Economic theory; Equilibrium; Error correction & detection; Exchange rates; Floating exchange rates; Foreign exchange; Foreign exchange rates; Inflation; International trade; Monetary policy; Nondurable goods; Price levels; Price stability; Prices; Prices and rates; Studies; U.S.A; United States > US
• ISSN: 0038-4038; 2325-8012
• DOI: 10.1002/j.2325-8012.1998.tb00113.x

Central banks that are primarily concerned with the behavior of prices will use monetary policy to try to insulate prices from exchange rate changes. Prices then appear unresponsive to changes in the exchange rate. The observed relationships between prices and the exchange rate will reflect central bank actions instead of the underlying relationship between exchange rates and prices. This paper explicitly recognizes the role that policy plays in determining the observable relationships between exchange rates and prices, and in so doing, it illustrates how the underlying relationships can be unraveled. Using three different empirical approaches, we examine the recent experience of the United States. We find that the prices of various nondurable goods, and even of some services, respond modestly to the exchange rate, and we find that the responses emerge most clearly when the role of monetary policy is explicitly considered. These findings are consistent with the hypothesis that the Federal Reserve acts to mitigate the effects of exchange rate fluctuations on domestic prices.