In the early years of exchange rate liberalization, it is expected to find close association between exchange rate movements and domestic prices. That is, countries that move from fixed to floating exchange rate regime will probably experience an increase in their domestic prices following the liberalization. Because of `fear of inflation', Egypt and Israel delayed the exchange rate liberalization process despite IMF's call for it. This paper is an attempt to investigate the impact of exchange rate movements on different prices in Egypt and Israel using a VAR approach. It also tests the validity of the Taylor hypothesis that low inflationary environment leads to a low exchange rate pass-through.

The phenomenon of Exchange Rate Pass-Through (ERPT) has long been a question of interest. It was rekindled in the 1970s by a combination of rising inflation and the adoption of more flexible exchange rate regimes in many countries following the demise of the Bretton Woods system of adjustable pegs. In this high-inflation environment, concern increased among central bankers about the potential effects of movements in their currencies on inflation (McCarthy, 2000).

Since then, a large body of economic literature has studied the ERPT to various domestic price measures. The empirical literature examines the role played by ERPT in both small as well as large economies.

McCarthy (2000) analyzes the impact of the exchange rate changes and import prices on producer and consumer prices in a recursive VAR framework. Using data from six industrialized OECD countries, he finds that the exchange rate has a modest effect on consumer prices. He also finds that the pass-through tends to be correlated with the value of consumer prices as well as the degree of trade openness of the country.

Goldfajn and Werlang (2000), in a panel study using a sample of 71 countries, find that the main determinants of pass-through are the cyclical component of output, the initial overvaluation of the real exchange rate, the initial rate of inflation, and the degree of openness. Among them, the real exchange rate misalignment is the most important determinant for emerging markets, while for developed countries, the most important determinant is initial inflation.

Choudhri and Hakura (2001), also using a 71-country data, consisting of both developed and developing nations, find a strong positive association between pass-through and the average inflation rate across countries. The inflation rate is found to dominate other macroeconomic variables in explaining cross-country differences in pass-through. Similarly, in 122 countries, Devereux and Yetman (2003) find a positive nonlinear relationship between pass-through and mean inflation and exchange rate.

Monetary Economics Journal, Exchange Rate Pass-Through, ERPT, Consumer Prices, Vector Autoregressive Models, Liberalization, Foreign Investments, Consumer Price Index Inflation, Wholesale Price Index Inflation, Monetary Policy, Akaike Information Criterion, ERPT Theories, Monetary Policy Instrument.