A New Test of Exchange Rate Pass-through in a Small Open Economy: Evidence from Asymmetric ARDL Bounds Approach

Abstract

In this paper, we investigate the asymmetric effect of exchange rate movements on prices in both expansion and recession cycles for the inflation targeting (IT) period in Turkey, from 2002:M1 to 2012:M10, by using a co-integrating non-linear auto regression distributed lag (NARDL) model. This method enables us to analyse an asymmetric short and long-run relationship between nominal exchange rate and domestic inflation rate. According to alternative calculations of depreciation and appreciation series, our results indicate that depreciation is passed through prices in the long run for all alternative series in expansion cycle, but appreciation is only passed through if the appreciation rate is calculated by more than four previous periods. Our findings further suggest that the magnitude of depreciation on prices is larger than appreciation. However, in the short run, although depreciation is passed through to the prices, appreciation is not. This finding implies that prices are sticky downwards but flexible upwards in the short run and business cycle is the main source of asymmetry.