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Monetary Policy and the Real Exchange Rate: Some Evidence

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  • John E. Floyd

Abstract

This paper examines the effects on real exchange rates of exogenous money supply shocks. Such shocks are conventionally associated with monetary policy, although they may also arise from shifts in the desired reserve to deposit ratio of the banking system or in the public's desired currency to deposit ratio. They necessarily involve nominal exchange rate movements and, given price rigidity, real exchange rate movements as well. No evidence is found that unanticipated money shocks affected real exchange rates in nine major industrial countries during the flexible exchange rate period that began with the collapse of the Bretton Woods system. Real shocks related to technological change, real income cycles, commodity market developments and, quite possibly, government fiscal policies explain virtually all the variability of real exchange rates. An extensive search also finds no evidence that real exchange rates were affected by anticipated money shocks. Since all sensible theories of real exchange rate behavior hold that exogenous unanticipated money shocks will necessarily affect real exchange rates, we are left with the conclusion that observed high-frequency monetary shocks are endogenously determined responses of the authorities to stochastic shocks to the demand for nominal money holdings associated with interest rate and exchange rate speculation and other factors. The evidence suggests that the authorities did a sufficiently good, though imperfect, job of smoothing financial markets to render the relationship between the real exchange rate and observed stochastic unanticipated money supply shocks statistically insignificant after other factors are taken into account.

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Bibliographic Info

Paper provided by University of Toronto, Department of Economics in its series Working Papers with number floyd-98-02.

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Length: 35 pages
Date of creation: 29 Jan 1998
Date of revision:
Handle: RePEc:tor:tecipa:floyd-98-02

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  1. Martin Eichenbaum & Charles Evans, 1992. "Some empirical evidence on the effects of monetary policy shocks on exchange rates," Working Paper Series, Macroeconomic Issues 92-32, Federal Reserve Bank of Chicago.
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  12. Pagan, Adrian, 1984. "Econometric Issues in the Analysis of Regressions with Generated Regressors," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 25(1), pages 221-47, February.
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  14. Sims, Christopher A., 1992. "Interpreting the macroeconomic time series facts : The effects of monetary policy," European Economic Review, Elsevier, vol. 36(5), pages 975-1000, June.
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Cited by:
  1. John E. Floyd, 1998. "Stochastic Monetary Interdependence, Currency Regime Choice and the Operation of Monetary Policy," Working Papers floyd-98-01, University of Toronto, Department of Economics.
  2. John E. Floyd, 1995. "Are Canadian Interest Rates Too High?," Canadian Public Policy, University of Toronto Press, vol. 21(2), pages 143-158, June.

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