Do Central Banks Respond to Exchange Rate Movements? Some New Evidence from Structural Estimation

This paper investigates whether and how exchange rate movements were taken into account in formulating monetary policy in Australia, Canada, New Zealand and the United Kingdom. We develop and estimate a structural general equilibrium two-sector model with sticky prices and wages, partial indexation on lagged inflation, a combination of both producer currency pricing and local currency pricing firms, and distribution services. Various forms of monetary policy rule and real exchange rate specifications are considered. Generally, with the real exchange rate specified endogenously and consistent with the structural model, the estimations lead to much higher marginal likelihood values than when the real exchange rate is specified exogenously. The estimation results of this paper lead us to favor the view that the Reserve Bank of Australia, the Bank of Canada and the Bank of England paid close attention to real exchange rate movements in the past, while the Reserve Bank of New Zealand did not seem to include exchange rate movements in their policy rule. On the one hand, the central bank of New Zealand seems to be less concerned about future inflation pressure induced by current exchange rate movements. On the other hand, the different structure of shocks in accounting for inflation and output variations in New Zealand, compared to the other three countries, suggests that it may be sufficient for the Reserve Bank of New Zealand to only respond to exchange rate movements indirectly through stabilizing inflation and output. Whats more, since exchange rate volatility might be emphasized when the expenditure-switching effect is small, if this effect were taken into account, the UK might benefit from higher exchange rate volatility. JEL Classification: F3, F4 Bank Classification: Exchange Rates; Monetary Policy Framework; International Topics ∗This paper has benefited from discussions with Charles Engel and Ehsan Choudhri. I thank Larry Schembri, Don Coletti, Robert Lafrance, Eric Santor, Ali Dib, Carlos De Resende, Philipp Maier, René Lalonde, Michael Francis, Michael King and numerous seminar participants for helpful comments. Contact: [email protected].