Exchange Rate Pass-Through and Inflation Dynamics in Ethiopia: A Markov Switching Approach

Exchange rate movements have been a determinant of inflation for long time and Ethiopia is not an exception. Thus, the study examines the effects of exchange rate variability on inflation in Ethiopia for data covering 1990Q1-2016Q4. Markov-switching methodology with Fixed Transition Probability (FTP) and Time Varying Transition Probability (TVTP) has been employed. Based on FTP the effect of changes in bilateral nominal exchange rate (NER) of Ethiopian birr per US dollar to inflation has been found insignificant. This result indicates absence of exchange rate pass-through to consumer price inflation in Ethiopia. The result obtained from TVTP, which used nominal effective exchange rate (NEER) as an exogenous variable and a determinant for the transition probability found exchange rate pass through to consumer price inflation. This implies that NEER is a better measurement for exchange rate pass-through. The study also attempted to test Taylor hypothesis for two inflation regimes, high and low. However, no evidence is found that supports the Taylor hypothesis in the case of Ethiopia.