How does monetary policy respond to exchange rate

Abstract

This paper analyzes how monetary policy has responded to exchange rate movements in six open economies, paying particular attention to the two-way interaction between monetary policy and the exchange rate. We address this issue using a structural VAR model that is identifyed using a combination of sign and short-term (zero) restrictions. Our suggested identification scheme allows for a simultaneous reaction between the interest rates and the exchange rate. Doing so we find that, while there is a instantaneous reaction in the exchange rate following a monetary policy shock in all countries, monetary policy responds on impact to an exchange rate shock in only four of the six countries. While this suggests that the exchange rate is not equally important in the interest rate setting in all countries, we find that accounting for a potential interaction is still crucial when identifying monetary policy shocks in open economies structural VARs.