ECB Policy Response to the Euro/US Dollar Exchange Rate

Abstract

The exchange rate is an important part of the transmission mechanism in the determination of monetary policy because movements in the exchange rate have signi…cant e¤ect on the macroeconomy. It can be di¢ cult to measure the reaction of monetary policy to the movements of the exchange rate, due to the simultaneous response of monetary policy to the exchange rate and the possibility that both variables respond to several other variables. This study addresses these problems by using an identi…cation method based on the heteroscedasticity in the high-frequency data. The results in this paper suggest that the ECB systematically responds to exchange rate movements but that quantitative effects are small. Such a signi…cant but small reaction coe¢ cient seems consistent with the hypothesis that the central banks do not target the ‡uctuations in the exchange rate but consider them only to the extent they impact on the expected in ‡ation and output path.JEL codes: E44, E52, G12