Exchange Rates and Monetary Policy

49 Pages Posted: 28 Jan 2016  

Vania Stavrakeva

London Business School

Jenny Tang

Federal Reserve Banks - Federal Reserve Bank of Boston

Date Written: 2015-10-29

Abstract

Financial markets regard exchange rate movements as conveying information about future expected policy rates. This paper explores the empirical link between conventional and unconventional monetary policy surprises and exchange rate fluctuations at a quarterly frequency. It examines these links using the currencies of ten developed economies calculated against four base currencies: the U.S. dollar, the British pound, the Deutschmark/euro, and the Japanese yen. Two periods are studied: 1990:Q1–2008:Q4, when the U.S. dollar hit the zero lower bound (ZLB) in December 2008, and the ZLB period between 2009:Q1 and 2015:Q1. The authors decompose exchange rate movements using a standard no-arbitrage asset pricing equation and two alternate interest rate forecasting models—a standard Taylor rule and a yield factor model. This decomposition reveals how contemporaneous unanticipated monetary policy surprises and changes in the expected future paths of policy are linked to exchange rate changes directly through relative interest rates as well as indirectly through expected excess returns and expected long-run exchange rate levels. The authors also use this decomposition to measure the fractions of the estimated effects of conventional and unconventional monetary policy surprises on exchange rate changes that are due to each component of the exchange rate change.

JEL Classification: E43, F31, G12, G15

Suggested Citation

Stavrakeva, Vania and Tang, Jenny, Exchange Rates and Monetary Policy (2015-10-29). FRB of Boston Working Paper No. 15-16. Available at SSRN: https://ssrn.com/abstract=2723768

Vania Stavrakeva (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Jenny Tang

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

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