Exchange Rate and Inflation Dynamics: Asymmetric Effects in a NARDL Framework

Inflation plays a crucial role in the macroeconomic dynamics of the Serbian economy. This paper examines the influence of the exchange rate on inflation for the period 2012:Q1-2021:Q4. The findings indicate that the impact of the exchange rate on price stability is one of the most important factors for a small and export-oriented Serbian economy. The asymmetric impact of the exchange rate on price growth has been demonstrated using the Nonlinear Autoregressive Distributed Lag (NARDL) model in the long and short run. There is a long-run relationship between inflation, export, economic growth, money supply, and exchange rate, which is confirmed by cointegration testing. Partial changes in the exchange rate with a positive sign manifest themselves in a depreciation that affects price stability. A 10 percent depreciation of Serbia’s national currency is expected to increase inflation by 2.38 percent. Conversely, a real exchange rate appreciation leads to a 0.39 percent rise in inflation, though this effect is not statistically significant. Over the long term, inflation responds more strongly to currency depreciation than to appreciation. The Error Correction Mechanism’s coefficient is statistically significant at the 1% level, indicating a relatively fast adjustment from short-term disequilibrium to long-term equilibrium. The study’s findings support the hypothesis that the real exchange rate has an asymmetrical short-term impact on Serbia’s inflation rate. Specifically, in the short term, a 1 percent depreciation of the national currency leads to a 0.27 percent increase in inflation. The obtained results are consistent with the relevant empirical findings. The correctness of the inflation targeting strategy and the choice of the managed floating exchange rate are indirectly examined and confirmed as the best strategic options for the Central Bank of Serbia. The policy implication of this study indicates that the further depreciation of the real exchange rate could be one of the main challenges for the Central Bank of Serbia to keep inflation under control.