ECB Policy Response to the Euro/US Dollar Exchange Rate

The exchange rate is an important part of transmission mechanism in the determination of monetary policy because movements in the exchange rate have significant effect on the macroeconomy. Measuring the reaction of monetary policy to the movements in exchange rate has some difficulties due to the simultaneous response of monetary policy on the exchange rate and the possibility that both variables respond several other variables. This study will use an identification method based on the heteroscedasticity in the high-frequency data. In particular, shifts in the importance of exchange rate relative to monetary policy shocks, and the estimated changes in the covariance between the shocks that result, allow us to measure the reaction of interest rates to changes in exchange rates. This study comes up with unbiased estimates with heteroscedasticity based identification approach and results of this paper suggest that ECB systematically respond to the exchange rate movements but that quantitative effects are small. The empirical results indicate that a 1 point rise (fall) in the exchange rate tends to decrease (increase) the three-month interest rate by around 20 basis points. Small and negative reaction coefficient implies that ECB may respond to the movements in exchange rate only to the extent warranted by their impact on the macroeconomy, since it affects the expected inflation and future output path.