Exchange Rate Pass-through into Domestic Prices: Evidence from India

Abstract

This study analyses the second-stage exchange rate pass-through (ERPT) into domestic prices in India over 1992–2022. Trend patterns show that the Wholesale Price Index (WPI), exchange rate (ER) and Index of Industrial Production (IIP) exhibit consistent upward movement, while the interest rate (IR) follows a relatively stable but declining trajectory. Using an autoregressive distributed lag model, the study explores the long-term association between inflation and its key determinants, ER, IR and IIP. Unit root tests indicate that WPI, ER and IIP are I(1), whereas IR is stationary at level. The bounds test confirms long-run cointegration, supported further by a negative and significant error-correction term, indicating that nearly 97% of short-run disequilibrium is corrected each year. In the long run, industrial production significantly increases wholesale prices, while higher IRs dampen them. Although the ER displays the expected positive relationship with WPI, its long-run impact remains statistically insignificant, implying limited evidence of sustained ERPT. In contrast, short-run dynamics reveal substantial effects of both ER changes and IR fluctuations on WPI. ER shocks pass through quickly, and IR movements similarly influence short-term inflation, highlighting their critical role in shaping immediate price behaviour. Structural breaks have been identified to study changes in the magnitude of ERPT over the periods of the structural breaks. Robustness checks have been carried out by including international oil prices as a determinant of inflation, followed by replacing the special drawing rights vis-à-vis the rupee with the real effective exchange rate as a proxy for the ER. JEL Codes: E31, E52, F31, F41