The Federal Reserve's response to exchange rate shocks

Abstract

This paper examines the extent to which the Federal Reserve has aimed to stabilize the dollar in the era of floating exchange rates. Wald tests and variance decomposition for a VAR model of the macroeconomy confirm that the Fed did respond to exchange rate shocks since 1973. Impulse responses of the federal funds rate to exchange rate shocks and exchange rate responses to policy shocks are found to be significant and mutually stabilizing. Dollar depreciation leads to a higher fed funds rate and a higher funds rate spurs dollar appreciation.