On the Empirical Relevance of The Exchange Rate as a Shock Absorber At the Zero Lower Bound

Abstract

The New Keynesian argument is that flexible exchange rate regimes cannot stabilize cyclical developments at the ZLB, as the real exchange rate appreciates in response to adverse demand shocks. We estimate the effects of a negative domestic demand shock on the real exchange rate for the euro area vis-à-vis the United States, Canada, and Japan by state-dependent sign-restricted local projection methods. We find a real depreciation when interest rates are not at the ZLB, but also when they are. The exchange rate can accommodate considerable variations in output, confirming its shock-absorbing capacity before and during the ZLB episode. The stabilizing role of the exchange rate is accompanied by a significant expansion of the ECB's balance sheet at the ZLB, while it remained unaffected in the pre-ZLB period. Our empirical results can be reconciled with an open economy New Keynesian model extended with unconventional monetary policy measures when interest rates are at the ZLB.

Keywords: Zero Lower Bound, Exchange Rate, Local Projections, State-dependent Effects, Unconventional Monetary Policy