Does a Big Bazooka Matter? Quantitative Easing Policies and Exchange Rates

65 Pages Posted: 29 Jan 2020

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)

Date Written: January 2020

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. The typical ECB or Federal Reserve expansionary QE announcement in our sample resulted in an increase in the relative balance sheet of about 20% and, in turn, in a persistent exchange rate depreciation of around 7%. 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 euro against the US dollar by reducing euro-dollar short-term money market rate differentials, by widening the cross-currency basis and by eliciting adjustments in "residual" deviations from interest parity. 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: CIP Deviations, QE Dynamic Effects, Signalling Channel of QE

JEL Classification: F41

Suggested Citation

Dedola, Luca and Georgiadis, Georgios and Grab, Johannes and Mehl, Arnaud, Does a Big Bazooka Matter? Quantitative Easing Policies and Exchange Rates (January 2020). CEPR Discussion Paper No. DP14324. Available at SSRN: https://ssrn.com/abstract=3526049

Luca Dedola (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Georgios Georgiadis

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

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