Estimating the Inflationary Effects of Depreciation

This paper adopts a simple econometric approach to estimate the effects of exchange rate changes on the rate of inflation in Australia. It uses a mark-up model of price determination, in which output costs are determined by input prices. The analysis suggests that imported cost pressures have been more important in the 1980s than in the 1970s. This may be attributable to increasing openness of the Australian economy over this period. In addition, an analysis of import prices finds no evidence of “absorption” by foreign suppliers, and suggests that Australian import prices could have fallen in 1986 if not for the depreciation. This finding is attributable to the falls in the world prices of tradeable goods in 1985 and 1986. Finally, a counterfactual simulation of the estimated equations suggests that the total price effects of the 1985 and 1986 depreciations have been considerably larger than commonly argued.