20 PACIFIC ECONOMIC BULLETIN Pacific Economic Bulletin Volume 21 Number 1 2006 © Asia Pacific Press This article examines the relationship between the value of the kina and the price level in Papua New Guinea. The pass-through from the exchange rate to inflation is estimated using data from 1989–2004. Pass-through is found to be higher than previously estimated and evidence is presented that pass-through has increased since the kina was floated. Although results display sensitivity to how inflation and the exchange rate are measured, the article concludes that pass-through to underlying inflation is approximately 50–60 per cent and is complete after between four and six quarters. The article also shows that exchange rate movements have been the main source of variation in inflation during the sample period. Thomas Sampson, Jeffrey Yabom, Williamina Nindim and Jacob Marambini work in the Research and Analysis Unit of the Bank of Papua New Guinea. Exchange rate pass-through in Papua New Guinea Thomas Sampson, Jeffrey Yabom, Williamina Nindim and Jacob Marambini How does the value of the kina affect prices in Papua New Guinea ? Economic theory and descriptive empirics both provide support for thinking that the exchange rate is likely to be one of the principal determinants of inflation. Papua New Guinea is a small, open economy with a high marginal propensity to import (Blyth 1991). A depreciation of the exchange rate can be expected to lead directly to higher prices for imports of both intermediate inputs and final goods. If firms choose to pass the import price increases on to consumers, domestic inflation will result. This inflation may in turn stimulate further price changes through ‘second round’ effects such as increases in inflation-indexed wages or demand shifts resulting from the initial price rises. One of the primary purposes of the ‘hard kina’ policy Papua New Guinea pursued from the time of independence until the kina was floated in 1994 was to avoid imported inflation by maintaining the value of the kina (Garnaut and Baxter 1983). A comparison of exchange rate movements and inflation rates before and after the floating of the kina in October 1994