Do Central Banks Respond to Exchange Rate Movements? A Markov-Switching Structural Investigation of Commodity Exporters and Importers

Abstract

We analyse whether central banks in small open commodity exporting and importing countries respond to exchange rate movements, taking into consideration that there may be structural changes in parameters and volatility throughout the sample. Using a Markov Switching Rational Expectations framework, we estimate the model for Australia, Canada, New Zealand, Norway, Sweden and the UK. We find that the size of policy responses, and the volatility of structural shocks, have not stayed constant during the sample. Furthermore, monetary policy has responded strongly to the exchange rate in many commodity exporters, most notably in Norway. This has had a stabilizing effect on the exchange rate. In particular, although the terms of trade are highly volatile among commodity exporters, the exchange rate has about the same volatility across all importers and exporters in the recent period.