Identifying Monetary Policy Shocks

People generally visualize monetary shocks as a univariate phenomenon, perhaps a change in the short-term interest rate, or a change in the monetary base. Up or down.

Over at Econlog, I recently argued that monetary shocks are a multivariate phenomenon. For example, a monetary shock might impact both the spot exchange rate and the forward exchange rate.

Here I’ll present a graph that illustrates various possible monetary shocks. I define Et at the spot price of foreign currency. Thus if Et gets bigger, then the domestic currency depreciates, and if Et gets smaller than the domestic currency appreciates.

In the graph below, the vertical axis shows the change in the one-year forward exchange rate (Et+1), while the horizontal axis shows the change in the spot exchange rate (Et). Each point the response of forex markets to an important monetary policy announcement:

(Click on image to enlarge)

The galaxy of points in the upper right quadrant represent expansionary monetary shocks, which cause the currency to depreciate in both the spot and forward markets, that is, “E” gets larger. I provide an example of when the US announced QE1 on March 18, 2009.

The galaxy of points in the lower-left quadrant are contractionary monetary shocks, such as the Swiss decision to let the franc float (appreciate) in January 2015.

You’ll notice that I also provided a 45-degree line, which shows whether the spot or the forward exchange rate responds more strongly to the monetary shock. Does it matter whether points lie slightly above or slightly below that 45-degree line? I’d say almost certainly not, but 99% of economists probably disagree with me.

If the spot rate moves by more than the forward rate, as in the March 2009 example, then nominal interest rates will fall with expansionary policy and rise with contractionary policy. If the spot rate moves by less than the forward rate, as in the January 2015 example, then nominal interest rates will rise with expansionary policy and fall with contractionary policy.

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