Monetary Policy and Exchange Rate
Interactions in an Open Economy
Hilde C. Bjørnland
University of Oslo
Workshop: Model Evaluation in Macroeconomics
University of Oslo, 6-7 May 2005
Background
ƒ
Recently there has been a great deal of interest in quantifying the
effects of monetary policy on macroeconomic variables using
structural VARs.
ƒ
Given new institutional set up with inflation targeting, one want to
understand if and how monetary policy affects the economy.
ƒ
VAR studies have been successful in extracting information useful
to evaluate the fit of DSGE models (Christiano et al., 2005; Altig et
al., 2003, for the closed economy and Adolfson et al., 2005, for the
open economy).
ƒ
Estimating the parameters of the DSGE model by matching
conditional dynamics in response to certain structural shocks
2
Monetary policy in closed economies
•
Consensus of the effects of monetary policy shocks on the closed
economies using VAR; Leeper et al. (1996) and Christiano et al. (1999,
2005)
•
“A contractionary monetary policy shock that increases the interest rate,
gradually lowers output and has a sluggish but eventually negative
effect on inflation (that peaks after 1-2 years)”.
•
Results found using VARs that are identified with some sort of
recursive identification strategy between the macroeconomic
environment and monetary policy.
•
Interest rates respond immediately to changes in macroeconomic
variables, but these variables respond with a lag to monetary policy
shocks.
3
Monetary policy in open economies
ƒ
Less of a consensus with regard to the effects of monetary policy, in particular
for the exchange rate
ƒ
Following a contractionary monetary policy, the real exchange rate either
ƒ depreciates (the exchange rate puzzle)
ƒ appreciates for a prolonged period of up to three years (delayed
overshooting or forward discount puzzle)
ƒ
Dornbusch’s (1976): A contractionary monetary policy shock (that increases
the domestic interest rates relative to foreign interest rates) will lead to an
impact appreciation followed by a persistent depreciation of the domestic
currency.
ƒ
This view underlies most models for policy analysis, as emphasised by Walsh
(2003):
4
Policy interest rate
Real exchange rate
5
Identification and previous results
ƒ Eichenbaum and Evans (1995), Kim and Roubini (2000) and Kim
(2000) for the G7 countries
ƒ Favero and Marcellini (2005), Peersman and Smets (2002) and Smets
and Wouters (2002) for the aggregate Euro area
ƒ Mojon and Peersman (2003) for individual Euro area countries and
Lindé (2003) for Sweden
ƒ Recursive structure between macroeconomic variables and monetary
policy (as in closed economies), plus either
ƒ the interest rate is restricted from responding immediately to
exchange rate shocks
ƒ the exchange rate is restricted from responding immediately to
monetary policy shocks
6
ƒ Persuasive puzzles are now considered stylized facts;
ƒ Although the nominal frictions in the model provides some persistence
in the real exchange rate following a policy shock, it is evident that the
model does not provide us with a hump-shaped response of the real
exchange rate which is a persuasive feature of estimated VARs.”
Adolfson et al. (2005, p.37)
ƒ The conflicting results may be due to the fact that the authors have not
addressed a possible simultaneity problem between monetary policy
and the exchange rate properly
ƒ Puzzles not data driven but due to the use of the wrong identification
scheme
ƒ Could be matching misspecified conditional dynamics in response to
monetary policy shocks
7
Alternative results
•
Sign restrictions: Faust and Rogers (2003), relax “dubious” restrictions. Test
the implications of the contemporaneous restrictions by instead imposing sign
restriction:
•
The delayed overshooting result is sensitive to dubious assumptions. Early
peak in the exchange rate. Scholl and Uhlig (2005) find more puzzles. Find
small effects of exchange rate variation due to monetary policy shocks.
•
However, by using only mild sign restrictions, they may no longer be able to
identify the items of interest
•
Event analysis where actual monetary policy actions that are perceived as a
surprise on the market are collected and analysed, Zettelmeyer (2004).
•
A surprise monetary policy shock that increases the interest rate has a
substantial appreciating effect on the exchange rate. Also for Norway.
•
This link between surprise monetary policy actions and initial exchange rate
responses could therefore be a feature that the identified VAR models at least
on impact should be able to replicate.
8
A solution to the simultaneity problem
•
We build on the traditional VAR literature in that we identify recursively a
standard structure between macroeconomic variables and monetary policy
•
However, our approach differs from the traditional method in that we also
allow monetary policy to respond to the contemporaneous exchange rate,
which itself is allowed to react simultaneously to all shocks.
•
We must have an alternative restriction in order to identify and orthogonalise
all shocks.
•
We therefore assume instead that monetary policy shocks can have no longrun effects on real exchange rates. Consistent with PPP with respect to
monetary policy shocks (Clarida and Gali, 1994).
•
By using only one long-run restriction, we address the simultaneity problem
without deviating extensively from the established literature of identifying a
monetary policy shock as an exogenous shock to an interest rate.
9
Simultaneity problem cont.
Traditional view: Cholesky
decomposition
Macroeconomic variables
(react with lag to monetary policy
and exchange rate news)
↑
Monetary policy variables
(react simultaneously to macro
variables, but with lag to
exchange rate news)
↑
Exchange rate
(reacts simultaneously to all
shocks)
Our decomposition:
Cholesky plus long run
restriction
Macroeconomic variables
(react with lag to monetary policy
and exchange rate news )
↑
Monetary policy ↔ exchange rate
(react simultaneously to each
other and to macro variables)
(Monetary policy shocks no long
run effect on real exchange
rates.)
10
Structural VAR;
Contemporaneous and long run restrictions
A(L)Z t =v t
Z t =B(L)v t
v t =Sε t
⎡S11
⎡ ∆i *⎤
⎢
⎢ ∆y ⎥
⎢S21
⎢
⎥
⎢π ⎥ = B( L) ⎢S31
⎢
⎢
⎥
∆
i
⎢S41
⎢
⎥
⎢S
⎢⎣ ∆e ⎥⎦
⎣ 51
t
0
0
0
S22 0
0
S32 S33 0
S42 S43 S44
S52 S53 S54
0 ⎤ ⎡ε
⎥ ⎢ε Y
0 ⎥⎢
0 ⎥ ⎢ε CP
⎥ ⎢ MP
S45 ⎥ ⎢ε
⎢
S55 ⎥⎦ ⎢ε ER
⎣
i*
⎤
⎥
⎥
⎥
⎥
⎥
⎥
⎥⎦ t
B51 (1)S14 +B52 (1)S24 +B53 (1)S34 +B54 (1)S44 +B55 (1)S54 =C54 (1)=0
11
Empirical study
•
Consider quarterly data for GDP, inflation, 3-month domestic and
foreign interest rate and the real exchange rate (5-VAR)
•
Augment to 8-VAR by including nominal wage, consumption,
investment
•
Sample 1993 (1988) – 2004
•
Variables modelled in levels (real exchange rate in differences). Allow
for implicit cointegration relationships in the data
•
Allow for trend and three impulse dummies reflecting pressure in the
kroner
12
Figure 1. Response to a monetary policy shock, using the Cholesky decomposition
a) Interest rate (percentage point)
b) Exchange rate (percentage)
1.2
1
1
0.8
0.6
0.8
0.4
0.6
0.2
0.4
0
0.2
-0.2
0
-0.4
-0.2
-0.6
-0.4
-0.8
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
1
c) GDP (percentage)
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
d) Inflation (percentage point)
0.3
0.15
0.2
0.1
0.1
0.05
0
0
-0.1
-0.05
-0.2
-0.1
-0.3
-0.15
-0.4
2
-0.2
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
13
Response in the interest rate and the real exchange rate to a
monetary policy shock, Cholesky decomposition;
(i-exc) or (exc-i) ordering
a) Interest rate
b) Exchange rate (pct.)
1.2
0.25
Interest rate Ii-exc)
Interest rate (exc-i)
1
Exchange rate (i-exc)
Exchange rate (exc-i)
0.2
0.15
0.8
0.1
0.6
0.05
0.4
0
0.2
-0.05
0
-0.1
-0.2
-0.15
-0.4
-0.2
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
14
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
15
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
16
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
17
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
18
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
19
Empirical results with Cholesky
decomposition
™ We find the traditional effects on output, consumption,
investment, inflation and the real wage from a monetary
policy shock
™ Lowers output and other real variables temporarily (min 5 qrts)
™ Slow and uneven response in inflation at first, but then inflation
and real wage fall significantly (min 8-10 qrts).
™ Persistence in the interest rate
™ Only weak evidence of an interaction between monetary
policy and exchange rates
™ If the interest rate is raised unexpectedly by 1 pp, exchange rates
appreciates (or even depreciates) by 0-0.2 %. Evidence of an
exchange rate puzzle and of delayed overshooting (8 qrts).
20
Response to a 1 pp MP shock, structural model
1.2
Interest rate
Interest rate (LR-restrict.)
1
0.4
Exchange rate
Exchange rate (LR-restrict.)
0.2
0.8
0
0.6
-0.2
0.4
-0.4
0.2
-0.6
0
-0.8
-0.2
-1
1
-0.4
1
2
3
4
5
6
7
8
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
0
0.05
Inflation
Inflation (LR-restrict.)
-0.01
0
-0.02
-0.03
-0.05
-0.04
-0.1
-0.05
GDP
GDP (LR-restrict.)
-0.15
-0.06
-0.07
-0.2
-0.08
-0.25
-0.09
-0.1
-0.3
1
1
2
3
4
5
6
7
8
9
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
21
Response to a 1 pp MP shock, structural model
a) Interest rate (percentage point)
b) Exchange rate (pct.)
1.2
0.6
1
0.4
0.2
0.8
0
0.6
-0.2
0.4
-0.4
0.2
-0.6
0
-0.8
-0.2
-1
-0.4
-1.2
1
2
3
4
5
6
7
8
1
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
c) GDP (percentage)
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
d) Inflation (percentage point)
0.1
0.3
0.2
0.05
0.1
0
0
-0.05
-0.1
-0.2
-0.1
-0.3
-0.15
-0.4
-0.5
22
-0.2
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Response to a 1 pp monetary policy shock, using baseline
structural VAR plus model augmented with nominal wage
0.6
Baseline
Baseline + nominal wage
st+
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
-1
-1.2
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
23
Summary of results
™ We find the traditional effects on output, inflation and the
nominal wage from a monetary policy shock
™ Lowers output and other real variables temporarily – effect larger
when no simultaneity problem (GDP ↓ 0.2-0.35 %). Minimum
after 5 quarters.
™ Inflation and real wage fall significantly, reaches minimum after
two and a half years (0.1- 0.15 %).
™ Persistence in the interest rate.
™ Strong evidence of an interaction between monetary policy
and exchange rates
™ If the interest rate is raised unexpectedly by 1 pp, exchange rates
appreciates by just less than 1 %.
™ No evidence of an exchange rate puzzle.
™ No evidence of delayed overshooting.
24
Further directions
•
Robustness with respect to
– Additional variables,
– Lag length
– Alternative long run restrictions
•
Additional countries
25