Exchange rate frameworks shape how movements in a currency translate into domestic prices because they alter incentives, expectations, and the structure of trade and distribution. Empirical literature shows this link: Charles Engel University of Wisconsin–Madison demonstrated that firms’ price-setting behavior responds to exchange rate volatility, and Gita Gopinath Harvard University emphasized how global value chains and invoice currency choices affect transmission into consumer prices. Together these findings explain why regimes matter.
Mechanisms linking regimes and pass-through
Under a fixed exchange rate the central bank commits to a nominal peg, which raises the role of credibility. If the peg is believable, firms and households expect stable relative prices, so exporters and importers are less likely to change markups when the external currency moves. Maurice Obstfeld University of California Berkeley has argued that such commitment can anchor inflation expectations, reducing the mechanical pass-through from exchange rates to domestic inflation. Conversely, when credibility is weak, a peg can mask underlying imbalances and produce sudden, large pass-through when devaluations occur.
In flexible exchange rate regimes, exchange rates absorb shocks instead of domestic prices doing so. Firms face more frequent currency swings and may adjust local prices more often or choose to invoice in a major currency like the US dollar. Gita Gopinath Harvard University shows that invoice currency and the share of imported inputs determine how much of an exchange move ends up in retail prices. Import composition matters: countries dependent on commodity imports or goods priced in foreign currencies exhibit higher pass-through.
Consequences and broader nuances
Different pass-through alters policy trade-offs. Low pass-through under a credible peg can shield consumers from imported inflation but may require sacrificing monetary independence and accumulating reserves. High pass-through in flexible regimes means monetary policy can respond to domestic shocks, yet consumers, especially low-income households in urban and rural areas, face more volatile prices. Territorial and cultural factors change outcomes: informal cross-border trade and nonstandard distribution networks can blunt or amplify pass-through in frontier regions, while economies with strong domestic retail margins see different translation from import costs to shelf prices.
Understanding the heterogeneity in pass-through helps policymakers choose and design exchange rate arrangements that reflect their institutional credibility, trade structure, and social vulnerabilities. Evidence from leading researchers underscores that regime type interacts with firm behavior, invoicing practices, and expectations to produce varied inflation outcomes.