Asymmetric Exchange Rate Pass‐Through

ABSTRACT This article investigates how asymmetric exchange rate pass‐through affects the welfare costs of domestic and foreign productivity shocks. This is achieved by modifying a standard two‐country dynamic general equilibrium model to include an exchange rate pass‐through parameter. This parameter is empirically estimated using the local projections method on a panel of 84 countries, showing that pass‐through is significantly higher during currency depreciations, in periods of higher inflation, and in countries with higher exchange rate volatility. The corresponding welfare simulations suggest that domestic productivity shocks are most costly in cases of currency depreciation, higher inflation, and higher exchange rate volatility, whereas foreign productivity shocks result in significantly greater welfare losses in cases of currency appreciation, lower inflation, and lower exchange rate volatility. These findings imply that to mitigate welfare losses, policymakers should account for asymmetric exchange rate pass‐through, considering both state‐dependent economic conditions and the origin of the shock.