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Are the changes always in the same direction? What magnitude of changes are observed for longer-term interest rates?

Monetary policy and currency wars: National economic interests vs international partnership

Foreign exchange market. How do the Bank's changes in the target overnight interest rate lead to changes in the exchange rate? How big a change in the exchange rate typically follows a change in the policy rate by the Bank of Canada? Interest sensitivity of spending.

REAL EXCHANGE RATE, MONETARY POLICY, AND THE U.S. ECONOMY: EVIDENCE FROM A FAVAR MODEL

How much, and over what timeframe, do aggregate consumption and investment respond to changes in longer-term interest rates? Do different components of consumption and investment have different responses to changes in interest rates? Sensitivity of net exports. How much do exports respond to a change in the exchange rate, and with what time lags?

How quickly and in what magnitude do imports respond to the same change in the exchange rate? The multiplier. How big is the "multiplier" that connects initial changes in aggregate demand to the overall change in aggregate output? Over what time period are the full effects on aggregate output observed? Excess demand or supply. How quickly does the excess demand or supply associated with any given output gap cause changes in the growth rate of wages and the prices of other inputs?

How quickly do these changes show up in inflation? Eight examples of the second type of uncertainty are shown in Chart 7 , with the yellow starbursts each referring to a different kind of shock that can affect the economy. A brief description of each is as follows:. Portfolio adjustments. For several reasons, creditors may decide to adjust their holdings of short-term and long-term Canadian securities, leading to changes in Canadian interest rates.

Changes in exchange rates occur daily and for many reasons, including changes in the growth of the global economy, changes in world commodity prices, and changes in international asset portfolios. Consumption and investment. Households change their spending, and firms change their investment plans, often in unpredictable ways. Expectations regarding future economic conditions are important. Government expenditures. Canadian governments federal, provincial, territorial, and municipal change their spending on an annual basis, sometimes in unexpected ways.

Net exports. Changes in foreign income lead to changes in the demand for Canadian exports.

Fixed Exchange Rate Regimes

The rise of specific countries in the production of certain goods frequently leads to changes in world demand, either away from or towards Canadian goods. Potential output. The economy's production capacity is not directly observable, and therefore must be estimated.

Its growth depends on labour-force growth, the accumulation of physical and human capital, and the growth of productivity. Changes in potential output often cannot be detected until well after the fact. Inflation expectations. Large and sudden changes in the prices of specific products frequently lead to changes in inflation expectations. However, the central bank's commitment and credibility help to anchor expectations in the face of such shocks.

Inflation shocks. The rate of inflation is regularly affected by changes in indirect taxes, sharp changes in the prices of specific products, and by changes in the exchange rate that alter the Canadian-dollar prices of imported products. Not every change in measured inflation is caused by excess demand or supply in the Canadian economy. This collection of uncertainties—about the economic linkages and the economic events—is crucial to the conduct of monetary policy, not least because of the long and variable lags that we discussed earlier.

For the Bank of Canada to set its policy interest rate now in order to keep inflation within its target range in the future, it is necessary for the Bank to anticipate the likely changes in the economy that will occur over the next two years. It is also necessary for the Bank to anticipate how its actions will be transmitted through the economy. Since no central bank has the ability to foretell the future or has perfect knowledge of the various linkages in the economy, this is a difficult task. But knowledge of the transmission mechanism, simplified as it is in Chart 7 , permits the Bank to be systematic about which questions it asks, and to be analytical about interpreting some of the answers.

This discussion underscores why monetary policy is best viewed as a problem of policy-making under uncertainty. Faced with such uncertainty, the Bank needs to be forward-looking, aware of many possible shocks that may occur in the near future. It must also be aware that economic developments shown to be present by current data may not persist for long, or may in the near future be revealed, through a revision of the data, never to have existed at all.

Monetary policy and currency wars: National economic interests vs international partnership

Not surprisingly, good judgment based on considerable experience is an essential part of good monetary policy. In addition to judgment and experience, consider what the Bank of Canada—and any other central bank—requires in order to conduct the best possible monetary policy in the face of uncertainty. To deal with the uncertainty regarding the various linkages between macroeconomic variables the pink balloons in Chart 7 , the Bank needs to conduct a significant amount of economic research , both theoretical and empirical, and to subject the results of this research to ongoing testing.

The nature of modern economies is such that this job will never be finished, and the complete set of answers will never be known. For example, even if the collection of economic researchers were able to estimate the precise relationship between changes in longer-term interest rates and firms' planned investment spending, there is no reason to believe this relationship will be stable over time, or that factors that proved to be important in the past will remain of central importance in the future.

Economic relationships depend in important ways on human behaviour, which itself depends on the specifics of time, place, and circumstance. In short, the economic relationships that are central to the conduct of monetary policy are difficult to pin down and are constantly changing. This simple fact requires the Bank to be continuously conducting research on the nature of the transmission mechanism. To do otherwise would be to abrogate its central responsibility. Dealing with the uncertain developments in the domestic and world economies the yellow starbursts in Chart 7 requires information of a different kind.

In order to know what events are occurring, and what events are likely to occur in the near future, the Bank needs to collect and analyze a great deal of current data—a process that is often called current analysis. Although the relatively small number of yellow starbursts in Chart 7 may suggest that the required effort in this direction is commensurately small, this suggestion would be misleading.

In fact, the large quantities of variables that feed into each yellow starburst, and the inherent complexity involved in understanding each individual variable, mean that the task of current analysis for any central bank is Herculean. Thus, a great many people at the Bank are assigned the task of collecting and analyzing data on hundreds of variables, from employment and exports to commodity prices and housing starts, from government spending and exchange rate regimes to domestic steel production and foreign crop failures.

Only when the various shocks to the economy are observed and understood can the Bank hope to incorporate that information fruitfully into its overall decision-making. A relatively new and important example of data collection and analysis that the Bank carries out in an attempt to better understand the emerging trends in the economy is the Business Outlook Survey BOS.

Four times a year the Bank's regional offices survey approximately firms, the overall sample chosen to be roughly representative of the Canadian economy. A number of issues are explored, including the firms' views on likely future demand for their own products, capacity pressures in their specific sectors, any emerging labour shortages, and the firms' own plans for hiring or expansion. By analyzing these data carefully, the Bank is able to better understand how Canadian firms respond to the various shocks affecting the Canadian economy.

Economic research and current analysis are not independent activities. In order to conduct thorough empirical economic research, knowledge of the data is essential, and such knowledge typically comes from experience in current analysis. Conversely, the ability to interpret current data—what is going on and why? This ongoing interaction between research and current analysis explains why many economists at the Bank of Canada are in positions that require a regular transition between current analysis duties and research projects.

The best example of how the insights gleaned from economic research are combined with the knowledge embodied in current analysis is in the Bank's regular projection, or forecasting, exercise, based on its large and complex statistical model of the Canadian economy, the Quarterly Projection Model QPM. Embodying the knowledge of economic relationships gained from many years of research, QPM is a mathematical representation of the interaction of the various agents in the Canadian economy—households, firms, and governments—and shows how these relationships must evolve over time to be consistent with the underlying assumptions of agents' behaviour.

The model then incorporates past and current data from the Canadian and world economies and projects the most likely future path of Canadian macroeconomic variables—including output, employment, wages, and prices. The world rarely turns out as the model projects, for two reasons. First, the model itself, though extremely complex, is nonetheless a highly simplified description of the real economy.

It lacks the remarkable and changing complexity that actually characterizes any modern economy. Second, the data that are fed into the model, as good as they are, are also imperfect, and the Bank's best predictions regarding what is actually happening in the Canadian and world economies may well turn out to be wrong in some way. Nonetheless, the economic projection provides the Bank with a logically consistent and well-articulated starting point regarding the future evolution of the Canadian economy, as well as a starting point for analyzing the likely future impact of its policy actions.

These three exercises in information creation—research, current analysis, and economic projections—are imperfect and, necessarily, ongoing. Research will never be entirely "correct" and thus will never be complete. Current analysis, by its very nature, must be an ongoing process, with constant effort expended to improve data definitions and accuracy. And the art of model building and producing sensible and consistent macroeconomic projections is, perhaps unbelievably, still in its infancy. Such failings, however, in no way suggest that these activities can be forsaken.

It would be impossible to conduct prudent monetary policy without the creation and provision of such information, and it is thus not surprising that central banks the world over invest considerable resources in these three key activities. Skip to content. Toggle navigation FR Toggle Search. Careers Take a central role at the Bank of Canada. Toward Reviewing the Monetary Policy Framework. Financial System Hub Promoting a stable and efficient financial system. Upcoming changes to legal tender status for older bank notes Find out what removing legal tender status means and which bank notes are affected.

Digital Currencies and Fintech Understanding digital currencies and related financial technologies is an important part of our research agenda. X t consists of a balanced panel of monthly U. The variables are log first differenced or first differenced to impose stationarity as in Kose, Otrok, and Whiteman RERN is used as the observable real exchange rate in our baseline model estimation. Factor 1, factor 2, and factor 3 are extracted from the large dataset of X t , representing, respectively, economic activity, price level, and monetary policy.

These results provide evidence that the factors are plausibly estimated. One way is to see how closely the estimated factor traces the indicator it is supposed to represent, that is, price level factor vs. This method is used by He, Leung, and Chong , 94, Figure. The second way is to check for the correlations between the estimated factors and the individual variables, as in An, Jin, and Ren , , Table. In our paper, both methods are used.

Following An, Jin, and Ren , we present the correlations table between the estimated factors and individual variables in Appendix C, Appendix S1. Both methods indicate that our assignment of the factors to the economic concepts is consistent with the literature. Real exchange rate seems to Granger cause economic activity factor and price factor but not vice versa. We find that causality runs from the exchange rate to the price factor, but not vice versa. The results from the use of the nominal exchange rate are reported in Table. No causality is found between the real exchange rate and the monetary policy factor, but when the real exchange rate is replaced with its nominal counterpart, causality runs in both directions.

But when we replace the real exchange rate with the nominal exchange rate, as done in Footnote 14, we find that causality runs both directions, from the exchange rate to monetary policy and from monetary policy to the exchange rate as well. These results make sense on a careful second thought.

The results of no causality when using the real exchange rate support the notion of price stickiness in the short run and the inability of monetary policy to influence prices within a month, where prices are reflected in the real exchange rate. This latter finding further supports the need to remove exchange rate fluctuation as a result of monetary policy shocks. In both cases, causality from the exchange rate to the monetary policy factor is larger than that from the monetary policy factor to the exchange rate.

These results support that: 1 our model identification scheme to further decompose the exchange rate fluctuations into that accounted for by U. The selected macroeconomic variables represent a wide spectrum of the U.

Seven lags are assumed. The plots show the impulse responses to a one standard deviation negative shock to the real exchange rate depreciation. When using 10, draws with the first 2, discarded, the impulse response of current account appears to be only marginally significant; but when using 15, draws and above, the results are highly significant across all models. As the posterior distributions converge better at higher number of draws, the statistical significance increases. For example, Chiu, Lee, and Sun find that the devaluation of the U. Interestingly, both exports and imports increase in response to the exchange rate depreciation shock.

The increase in export is statistically significant and consistent with conventional theory. Higher imports after a depreciation shock indicate that the demand for imports is inelastic and the higher price of imports more than offsets the lower quantity Levi Our results seem to suggest that this condition is not met for the U. Landon and Smith document an important finding; the authors differentiate exchange rate movements with respect to import source and those with respect to export destination countries, and find that a currency depreciation from the former has a negative direct cost effect while that from the latter has a positive derived demand effect on imports of machinery and equipment.

They further find that the net effect on import is negative but insignificant. Since both U. Import price and export price both increase over time in response to exchange rate depreciation shock. Exchange rate depreciation shock appears expansionary to the U. Industrial production, manufacturing both durable and nondurable manufacturing , capacity utilization rate, and ISM purchasing manager's index all increase in response to the depreciation shock over time.

Further, unemployment rate falls, employment, especially nonagricultural employment and payroll, and the ISM manufacturing employment index all increase. All of the above results are statistically significant. Average weekly hours worked increase but the result is only marginally significant; average nominal hourly earnings increase and the result is statistically significant.

Interest Rates and Exchange Rates

Our findings are consistent with the existing literature. For example, Klein, Schuh, and Triest find that a depreciation shock in the cyclical component of the U. This view is shared by, among others, Burgess and Knetter , Goldberg and Tracy ; the authors document that the U. It appears that an exchange rate depreciation shock is inflationary to the U.

Similar to the import price and export price discussed earlier, consumer price index, producer price index for both finished goods and all commodities, and the ISM manufacturing price index all increase over time to the exchange rate depreciation shock. With the rising prices, consumer confidence falls. All results are statistically significant.


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Real personal consumption exhibits a transitory rise but the result is statistically insignificant. Auer also confirms that a U. Monetary policy seems to be leaning against the wind. An exchange rate depreciation shock leads to a rise in the federal funds rate and a fall in the M2 money supply. Our findings are consistent with Choudhri and Hakura , who assert that the Fed tightens the money supply after depreciation to reduce the inflationary effects on the economy.

Exchange rate depreciation shock also appears to have positive effects on the stock market and the housing market. As a result, the stock prices can drop. Furthermore, investors tend to sell equity denominated in the depreciating currency as they are concerned about lower financial profits due to depreciation, which can cause additional negative impact on the economy.

On the other hand, Gavin finds that a dollar depreciation boosts both profits from overseas operations of U. Given the increasing financial linkages of the United States with the rest of the world as discussed at the beginning of the paper, we have reasons to believe that the latter force dominates. In summary, impulse response results of key macroeconomic variables support the view that exchange rate depreciation shock is expansionary and inflationary to the U.

First, exchange rate depreciation shock decreases unemployment rate and increases industrial production, manufacturing, employment, nonagricultural payroll, capacity utilization, export, nominal earnings, hours worked, housing start, and stock market prices. Second, the depreciation shock improves the U. Third, the depreciation shock leads to a rise in all prices—import price, export price, consumer price, producer price, and the ISM manufacturing price index.

Finally, monetary policy in the United States appears to be leaning against the wind; the Fed follows a contractionary monetary policy to stabilize the economy post the exchange rate depreciation shock. Our results are consistent with the existing literature. The fourth column in Table 3 shows the contribution of the exchange rate shock to the forecast error variance of a selected variable. Clearly the foreign exchange market breeds their own shocks, and these shocks appear to play a nontrivial role in accounting for fluctuations in the U.

Finally, the R 2 column shows that our model has pretty good explanatory power comparable to many similar studies in the literature. All results from 1 through 6 are qualitatively similar to those obtained from the baseline model. During the Great Moderation period — , the current account declines in response to a depreciation shock and takes a much longer time to stabilize, and the results are not statistically significant.

We further find that stock prices and consumer price index both record an increase, but again the results are not statistically significant. In sum, our results for the Great Moderation period support the stability of the U. All other results stay qualitatively the same. In Bernanke, Boivin, and Eliasz , the monetary policy is represented by the observable federal funds rate FFR , while in our baseline model, monetary policy is represented by a latent factor from a group of related interest rate and monetary aggregate variables. Our main focus is to examine the effects of exchange rate shock, therefore, we use the real exchange rate as the observable variable.

However, in this section we do check if using the observable federal funds rate as an indicator of monetary policy potentially introduces any major changes to our results or not. It is necessary to include the monetary aggregate factor extracted from variables such as M1, M2, and other quantitative measures of money in our FAVAR in order to correctly identify the monetary policy shock. The results are fairly consistent see Figure AE In the first step step I , we estimate the latent factors using the principal component approach and record the factor loadings.

For example, economic activity factor is estimated from 95 variables reflecting production, employment, housing, consumption, and trade variables; the price level factor from 23 consumer and producer price variables, the interest rate factor from eight different types of short term and long term interest rates, and monetary aggregate factor from seven quantitative measures of money variables.

The real exchange rate is used as the observable variable. We use a broad measure of interest rate in the form of a latent factor, over the federal funds rate as a single observable as in Bernanke, Boivin, and Eliasz In particular, we load eight different indicators of the interest rate, and then we estimate the first principal component as a measure of the policy rate.

Kim for example argues that firms do not change their output and price unexpectedly in response to unexpected changes in financial signals or monetary policy within a month due to adjustment costs and planning delays. We identify the exchange rate shock using Cholesky decomposition, and compute the impulse responses of the estimated factors to the exchange rate depreciation shock see Figure AE We then use the factor loadings from step I to compute the impulse responses of the full set of observable variables to the exchange rate depreciation shock see Figure AE For the complete algorithm, refer to Stock and Watson and Bahadir and Lastrapes.

Our main finding still holds, that is, the exchange rate shock is expansionary and inflationary to the U. In response to an exchange rate depreciation shock, economic activity expands, prices increase, interest rates increase, and money supply falls, indicating that monetary policy is leaning against the wind. Industrial production, employment, nonagricultural payroll, stock price, and consumer price index all increase in response to the depreciation shock, and unemployment falls. Full set of results from principal component analysis similar to those shown for the baseline model will be made available upon request.

In sum, our results from the baseline model are highly reliable and robust to all changes in model parameters, model specifications, and estimation procedures. Real exchange rate is the observable variable. We define the exchange rate shock as exogenous disturbances originating from the foreign exchange market, and movements in exchange rate that are not accounted for by changes in the U.

We identify the exchange rate shock following a recursive identification scheme and Cholesky decomposition. We then examine the effects of this exchange rate shock to the broad U. Our impulse response and variance decomposition results support the following conclusions: 1 we find that an exchange rate depreciation shock does help improve the U. Our results imply that monetary policy alone is not enough to stabilize the effects of exchange rate shocks to the U. Other measures are called for to mitigate the potential nontrivial effects of exchange rate shocks arising from external and foreign exchange markets to the U.

Some caveats remain. One major issue is that our model is linear and symmetric, that is, it treats exchange rate depreciation and appreciation shocks symmetrically, and therefore cannot draw inferences for how exchange rate appreciation and depreciation may affect the U. Second, the post—Bretton Woods period spans a long time and the U.

It is in the authors' intention to continue the current research along these directions. Please note: The publisher is not responsible for the content or functionality of any supporting information supplied by the authors. Any queries other than missing content should be directed to the corresponding author for the article. Volume 57 , Issue 1. If you do not receive an email within 10 minutes, your email address may not be registered, and you may need to create a new Wiley Online Library account.

If the address matches an existing account you will receive an email with instructions to retrieve your username. Economic Inquiry Volume 57, Issue 1. Original Article Free Access. Wei Sun E-mail address: sunw gvsu. Kuhelika De E-mail address: dek gvsu. William D. Lastrapes for valuable suggestions. We also thank the conference participants at the Western Economic Association International meetings for helpful discussions. All remaining errors are our own.

Search for more papers by this author. Tools Request permission Export citation Add to favorites Track citation. Share Give access Share full text access. Share full text access. Please review our Terms and Conditions of Use and check box below to share full-text version of article. Abstract This paper examines the effects of exchange rate depreciation to the U.

Figure 1 Open in figure viewer PowerPoint. Openness of the U. Economy—Export and Import as a Percentage of U. Figure 2 Open in figure viewer PowerPoint. FDI as a Percentage of U. Figure 3 Open in figure viewer PowerPoint. We assume that X t are related to the unobservable factors F t and the observable real exchange rate Y t in the following observation equation: 1.


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