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ECB Policy Response to the Euro/US Dollar Exchange Rate

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  • Demir, Ishak

Abstract

The exchange rate is an important part of transmission mechanism in the determination of monetary policy because movements in the exchange rate have significant effect on the macroeconomy. Measuring the reaction of monetary policy to the movements in exchange rate has some difficulties due to the simultaneous response of monetary policy on the exchange rate and the possibility that both variables respond several other variables. This study will use an identification method based on the heteroscedasticity in the high-frequency data. In particular, shifts in the importance of exchange rate relative to monetary policy shocks, and the estimated changes in the covariance between the shocks that result, allow us to measure the reaction of interest rates to changes in exchange rates. This study comes up with unbiased estimates with heteroscedasticity based identification approach and results of this paper suggest that ECB systematically respond to the exchange rate movements but that quantitative effects are small. The empirical results indicate that a 1 point rise (fall) in the exchange rate tends to decrease (increase) the three-month interest rate by around 20 basis points. Small and negative reaction coefficient implies that ECB may respond to the movements in exchange rate only to the extent warranted by their impact on the macroeconomy, since it affects the expected inflation and future output path.

Suggested Citation

  • Demir, Ishak, 2012. "ECB Policy Response to the Euro/US Dollar Exchange Rate," MPRA Paper 36744, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:36744
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    References listed on IDEAS

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    Cited by:

    1. Qin, Jing & Ge, Jintian & Lu, Xinsheng, 2018. "The effectiveness of the monetary policy in China: New evidence from long-range cross-correlation analysis and the components of multifractality," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 506(C), pages 1026-1037.
    2. Miah, Fazlul & Khalifa, Ahmed Ali & Hammoudeh, Shawkat, 2016. "Further evidence on the rationality of interest rate expectations: A comprehensive study of developed and emerging economies," Economic Modelling, Elsevier, vol. 54(C), pages 574-590.
    3. Kiss, Gábor Dávid & Mészáros, Mercédesz, 2019. "Árfolyam-modellezés nem konvencionális monetáris politika mellett
      [Exchange rates and unconventional monetary-policy instruments]
      ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(9), pages 960-979.
    4. Mahdi Barakchian, S., 2015. "Transmission of US monetary policy into the Canadian economy: A structural cointegration analysis," Economic Modelling, Elsevier, vol. 46(C), pages 11-26.
    5. Andrieș, Alin Marius & Căpraru, Bogdan & Ihnatov, Iulian & Tiwari, Aviral Kumar, 2017. "The relationship between exchange rates and interest rates in a small open emerging economy: The case of Romania," Economic Modelling, Elsevier, vol. 67(C), pages 261-274.
    6. Keiichi Goshima & Yusuke Kumano, 2018. "Monetary Policy Announcement and Algorithmic News Trading in the Foreign Exchange Market," IMES Discussion Paper Series 18-E-13, Institute for Monetary and Economic Studies, Bank of Japan.
    7. Muhammad Arshad Khan & Saima Nawaz, 2018. "Does Pak-Rupee Exchange Rate Respond to Monetary Fundamentals? A Structural Analysis," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 57(2), pages 175-202.
    8. Kiss, Gábor Dávid & Kovács, György & Varga, János Zoltán, 2016. "Várakozások és a monetáris politika - különös tekintettel a magyarországi gyakorlatra
      [Expectations and monetary policy, with special attention to practice in Hungary]
      ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(11), pages 1192-1216.
    9. Goczek, Łukasz & Partyka, Karol J., 2019. "Too small to be independent? On the influence of ECB monetary policy on interest rates of the EEA countries," Economic Modelling, Elsevier, vol. 78(C), pages 180-191.

    More about this item

    Keywords

    Monetary Policy; Exchange Rates; Identi�cation through Heteroscedasticity; European Central Bank; Monetary Policy Reaction;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General

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