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

25 Pages Posted: 12 Nov 2013

See all articles by Ragna Alstadheim

Ragna Alstadheim

Norges Bank

Hilde C. Bjørnland

Norwegian School of Management (BI); Norges Bank

Junior Maih

Norges Bank

Date Written: October 8, 2013

Abstract

Do central banks respond to exchange rate movements? According to Lubik and Schorfheide (2007) who estimate structural general equilibrium models with monetary policy rules, the answer is "Yes, some do". However, their analysis is based on a sample with multiple regime changes, which may bias the results. We revisit their original question using a Markov switching set up which explicitly allows for parameter changes. Fitting the data from four small open economies to the model, we find that the size of policy responses, and the volatility of structural shocks, have not stayed constant during the sample period (1982-2011). In particular, central banks in Sweden and the UK switched from a high response to the exchange rate in the 1980s and early 1990s, to a low response some time after inflation targeting was implemented. Canada also observed a regime change, but the decline in the exchange rate response was small relative to the increase in the response to inflation and output. Norway, on the other hand, did not observe a shift in the policy response over time, as the central bank has stayed in a regime of high exchange rate response prior and post implementing inflation targeting.

Keywords: Monetary policy, exchange rates, inflation targeting, markov switching, small open economy

JEL Classification: C68, E52, F41

Suggested Citation

Alstadheim, Ragna and Bjørnland, Hilde C. and Maih, Junior, Do Central Banks Respond to Exchange Rate Movements? A Markov-Switching Structural Investigation (October 8, 2013). Norges Bank Working Paper 24, Available at SSRN: https://ssrn.com/abstract=2353019 or http://dx.doi.org/10.2139/ssrn.2353019

Ragna Alstadheim (Contact Author)

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Hilde C. Bjørnland

Norwegian School of Management (BI) ( email )

P.O. Box 580
N-1302 Sandvika
Norway

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Junior Maih

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
150
Abstract Views
841
rank
267,310
PlumX Metrics