Page 22 - Azerbaijan State University of Economics

Vugar Rahimov, Nigar Jafarova: The Exchange Rate Pass-Through to Aggregate
Consumer Price Index and Its Components In Azerbaijan

Figure 2. Co-movement of nominal effective exchange rate* and Consumer Price
Index (2003-2021)
30 40
Consumer Price Index, YOY, %
25 NEER, YOY, % (right scale) 30
20
20
10
15
0
10
-10
5
-20
0 -30
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-5 2021* -40

* A rise in NEER indicates appreciation of the local currency against the trading
partners’ currencies.
nd
** 2021 corresponds 2 quarter of 2021

As we mentioned above, tightly managed exchange rate system limited the ERPT to
domestic inflation in Azerbaijan. Sharp appreciation observed during 2009 in
Azerbaijan might be linked to disinflation activities to prevent high inflation rates
during 2008.

The oil price shocks in 2014-2015 that hit the economies induced greater flexibility
in the exchange rate policy which heightened the pass-through effects and
consequently, elevated domestic inflation rates. After transition to a managed
floating regime, NEER of Azerbaijan manat has experienced almost 40 percent
depreciation and thus, the shock transmitted to local prices in the following years.
After two consecutive high inflation years, the Central Bank managed to stabilize
the inflation through tight monetary policy and relatively stable exchange rate. In the
methodology part, we try to assess empirically the relationship between these two
variables using VAR model in first differences.

3. THEORETICAL FRAMEWORK
The existence of the perfect ERPT to CPI stems from the Law of One Price and
Purchasing Power Parity principle assuming that the equilibrium price of a particular
good in two markets cannot be different if expressed in the same currency. It also
assumes that there are no transportation costs and no differential taxes applied in the
economy. Empirically however, these theories cannot be confirmed.

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