Does a Big Bazooka Matter? Central Bank Balance-Sheet Policies and Exchange Rates

42 Pages Posted: 16 Nov 2018

See all articles by Luca Dedola

Luca Dedola

Bank of Italy; European Central Bank (ECB)

Georgios Georgiadis

European Central Bank (ECB)

Johannes Gräb

European Central Bank (ECB)

Arnaud Mehl

European Central Bank (ECB)

Multiple version iconThere are 2 versions of this paper

Date Written: November 14, 2018

Abstract

We estimate the effects of quantitative easing (QE) measures by the ECB and the Federal Reserve on the US dollar-euro exchange rate at frequencies and horizons relevant for policymakers. To do so, we derive a theoretically-consistent local projection regression equation from the standard asset pricing formulation of exchange rate determination. We then proxy unobserved QE shocks by future changes in the relative size of central banks' balance sheets, which we instrument with QE announcements in two-stage least squares regressions in order to account for their endogeneity. We find that QE measures have large and persistent effects on the exchange rate. For example, our estimates imply that the ECB's APP program which raised the ECB's balance sheet relative to that of the Federal Reserve by 35 percentage points between September 2014 and the end of 2016 depreciated the euro vis-à-vis the US dollar by 12%. Regarding transmission channels, we find that a relative QE shock that expands the ECB's balance sheet relative to that of the Federal Reserve depreciates the US dollar-euro exchange rate by reducing euro-dollar short-term money market rate differentials, by widening the cross-currency basis and by eliciting adjustments in currency risk premia. Changes in the expectations about the future monetary policy stance, reflecting the "signalling" channel of QE, also contribute to the exchange rate response to QE shocks.

Keywords: quantitiative easing, interest rate parity condition, CIP deviations

JEL Classification: E5, F3

Suggested Citation

Dedola, Luca and Georgiadis, Georgios and Grab, Johannes and Mehl, Arnaud, Does a Big Bazooka Matter? Central Bank Balance-Sheet Policies and Exchange Rates (November 14, 2018). ECB Working Paper No. 2197. Available at SSRN: https://ssrn.com/abstract=3285084

Luca Dedola

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Georgios Georgiadis (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Johannes Grab

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Arnaud Mehl

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Register to save articles to
your library

Register

Paper statistics

Downloads
24
Abstract Views
142
PlumX Metrics
!

Under construction: SSRN citations will be offline until July when we will launch a brand new and improved citations service, check here for more details.

For more information