In theory, an exogenous increase in the policy interest rate should lead to a decline in inflation, assuming the demand side effects dominate the supply side effects. However, for emerging market economies many empirical studies based on structural vector autoregressions (SVARs) find that an increase in the policy rate is followed by a rise in prices, a phenomenon known as the price puzzle (e.g., Sims, 1992). One explanation for this puzzle is the misidentification of monetary policy shocks (Ramey (2016). To address this issue, some studies have incorporated proxies for inflation expectations (Sims, 1992; Ha et al., 2025).
An alternative explanation is provided in my paper presented at the ACAES session at the 2026 Allied Social Science Association Annual Meeting. Using high-frequency analysis of monetary policy shocks in Asian economies, the paper shows that positive shocks lead to a depreciation of the exchange rate. The price puzzle arises from this depreciation and the associated exchange rate pass-through to domestic prices. Once this indirect channel is accounted for, the price puzzle disappears, and monetary tightening is seen to achieve the intended lower inflation in the medium term.
The study makes use of daily data from 2003 to 2024 (subject to availability) for eight Asian economies – India, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, and Thailand – to identify high-frequency monetary policy shocks. Specifically, forward exchange rates against the U.S. dollar, together with spot exchange rates, are used to compute the percentage-point change in the forward discount within a two-day window around monetary policy announcements. Under the covered interest parity (CIP) condition, changes in the forward discount reflect changes in interest rate differentials. Assuming that U.S. interest rates and factors driving deviations from CIP remain constant within this narrow window, the change in the forward discount provides a measure of monetary policy shocks in these economies.
This approach is similar to Witheridge (2024) and is motivated by the absence of financial instruments – such as policy rate futures (e.g., Fed Funds futures in the U.S.) – that are commonly used to identify monetary policy shocks in advanced economies. We conduct extensive robustness checks by constructing CIP-based monetary policy shocks for the U.S., the U.K., and India and comparing these with standard policy rate futures-based measures of monetary policy shocks. The CIP-based shocks exhibit a close relationship with policy rate futures-based measures of monetary policy shocks in these countries, supporting the view that our approach captures exogenous monetary policy shocks for our Asian economies.
Following Cloyne et al. (2023), we estimate the effect of the monetary policy shock on inflation and the exchange rate using local projection and obtain the dynamic response of inflation and the exchange rate. Figure 1 presents the impulse response of inflation to a positive monetary policy shock of one percentage point for the eight economies in our sample. Consistent with the price puzzle, a contractionary policy shock leads to an increase in inflation, with a peak effect of nearly 0.4 percentage points by seven months after the shock. The increase in inflation coincides with depreciation of the exchange rate as shown in Figure 2. Peak depreciation is around 2 percentage points at nine months after the shock. Together, these two responses suggest that the increase in inflation may be due to the pass-through of higher import costs to domestic prices.
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Figure 1. |
Figure 2. |
We further estimate a local projection specification that includes the exchange rate and its interaction with the monetary policy shock to capture the indirect effect of monetary policy on inflation. Within this framework, the coefficient on the policy shock reflects the direct effect of monetary policy on inflation, net of the exchange rate channel. The results are presented in Figure 3. As shown, once the indirect effect operating through the
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Figure 3. |
exchange rate is accounted for, the price puzzle disappears. Consistent with theory, inflation declines in the medium run following a contractionary monetary policy shock.
In sum, we find that in Asian economies monetary tightening leads to an exchange rate depreciation, in contrast to the evidence from advanced economies. This depreciation is broad-based, affecting both nominal and real effective exchange rates. Our results indicate that a policy rate increase raises inflation through depreciation of the exchange rate and the associated pass-through to domestic prices. This suggests that the price puzzle documented in the literature may arise from an indirect channel operating through the exchange rate.
This mechanism is particularly relevant for emerging markets, where monetary tightening can weaken the currency, unlike in advanced economies such as the U.S. (Bolhuis et al., 2024), where it typically leads to an appreciation. These findings highlight the complex trade-offs faced by central banks in emerging markets when using interest rate policy to control inflation.