Do Central Banks Respond to Exchange Rate Movements? A Structural Investigation

We estimate a small-scale, structural general equilibrium model of a small open economy using Bayesian methods. Our main focus is the conduct of monetary policy in Australia, Canada, New Zealand and the U.K., as measured by nominal interest rate rules. We consider generic Taylor-type rules, where the monetary authority reacts in response to output, inflation, and exchange-rate movements. We perform posterior odds test to investigate the hypothesis whether central banks do respond to exchange rates. The main result of this paper is that the central banks of Australia, New Zealand and the U.K. do not, whereas the Bank of Canada does include the nominal exchange rate in its policy rule. This result is robust for various specification of the policy rule, among them an MCI-based rule. Additionally, we find that, based on variance decomposition of the estimated model, that terms-of-trade movements do not contribute significantly to domestic business cycles.