An Analysis of Exchange Rate Pass-Through and Impact on Domestic Inflation in Sri Lanka

Continuous depreciation of Sri Lanka Rupee and huge inflation due to skyrocketing of fuel and food prices Sri Lanka is now experiencing an external imbalance as well as instability in the domestic economy. Policy makers are confronting enormous challenges due to these external shocks and domestic shocks that would hinder to effective policy implementation. Therefore, an analysis of external shocks and the exchange rate pass-through has now become timely important area to understand the size and the degree and its real impact on the economy. Therefore, this paper examines the effectiveness of exchange rate pass-through to import price, producer price and consumer price and impact on the inflation in Sri Lanka. For this purpose, the analysis is based on a Vector Auto Regression (VAR) approach for the period of 2010Q1 -2021Q4.The findings of this study confirms that the pass-through effect of external shocks on exchange rate and exchange rate on import price, producer price and consumer price are incomplete. The impact of change in the exchange rate on the import price shows that the one percent depreciation of Sri Lanka rupee results to increase the import price index by 0.31 percent in the first quarter and 0.42 percent in the second quarter. The pass-through effects of exchange rate on consumer price also incomplete across all the periods. The consumer price increases by 0.22 percent when the domestic currency depreciates by a one percent. However, in the fourth quarter, it shows a negative response confirming that consumer price decrease by 0.36 percent when the nominal effective exchange rate increases one percent. The estimated results suggests that the pass-through effects of international oil price shocks and exchange rate shocks appear to be quite ambiguous and provides puzzling results for some periods.