Does Monetary Policy Credibility Impact the Responses of Unit Labour Costs to Exchange Rate Depreciation Shocks?

Abstract

We examine whether monetary policy credibility impacts the responses of growth of unit labour costs (ULC) to exchange rate depreciation shocks. Both, the linear regressions and VAR analysis indicates the ULC rises much higher to exchange rate depreciation shock in high inflation regime than in the low regime. The counterfactual ULC reaction exceeds the actual responses, indicating to the potency of policy credibility indicator in dampening the pass-through. This indicates that high monetary policy credibility weaken the increase in ULC to exchange rate depreciation shocks. This implies that policymakers should be aware that the risk to inflationary pressures due to exchange rate depreciation shocks via the ULC channel are much weaker when inflation is below or equal to the 6% threshold.