The exchange rate and the price level in a small open economy: Botswana

How valid is the small open economy pricing assumption in a genuinely small open economy? This article first considers the extend and speed of pass-through of foreign price and exchange rate changes to domestic prices for the case of a classics small open economy: Botswana. The evidence, in contrast with the evidence of incomplete pass-through for large industrial countries, is that 100% of foreign price level and exchange rate changes pass through to the Botswana price level. The pass-through is not instantaneous. Adjustment has a half-life of about 15 months. The empirical results are then used to model the effect of alternative exchange rate policies—fixed exchange rate, gradual change, and discrete change—on inflation and on the real exchange rate. Because of the lag in pass-through of exchange rate changes, there is a trade off between the competitive position and imported inflation.