Exchange Rate Changes and the Economy

Sterling’s recent weakness raises important questions about the impact on inflation and UK competitiveness. A crucial part of the answer is the extent of Exchange Rate Pass-Through (ERPT), the extent to which domestic
prices respond to exchange rate shifts. A high ERPT would mean a substantial inflation impact and a low competitiveness effect. After the 1990s, ERPT decreased in most countries, including the UK. However, ERPT varies across episodes. Currently, higher and more variable inflation, foreign exchange weakness skewed towards the dollar, and damaged Bank of England credibility, implies a high ERPT. This higher ERPT argues for a firm monetary policy response.