Abstract
In this study, Panel Vector Autoregression (PVAR) models are used to determine the impacts of exchange rate volatility on industrial production growth rate, consumer price inflation, short-term interest rates and stock returns for 10 OECD countries. The variance decompositions (VDCs) found that exchange rate volatility can be a secondary factor for the variations in immediate interest rates, implying that Uncovered Interest Rate Parity (UIP) condition should be analyzed by the inclusion of other macroeconomic variables. Impulse response functions (IRFs) expose that volatility in exchange rates can have a positive impact on the liquidity conditions in money market and an increase in real economic activity because investors have to move their money away from currency markets to money markets. The relatively lower impact of exchange rate volatility may arise from the zero bound problem, thus it is emphasized that the examination of impacts on exchange rate volatility on macroeconomics variables should be made both considering conventional and unconventional monetary policy. Although impulse response functions (IRFs) did not detect the significant impact of exchange rate volatility on inflation, VDCs obtained supporting results to exchange rate pass-through (ERPT). I suggest that the monetary policy to be developed should clarify alternative channels that exchange rate may affect inflation.
Highlights
Introducing financial variables other than exchange rates into the Taylor rule to explore the linkages among economic activity and the financial sector has become familiar102 Trade and Global Market practice in the monetary policy setting [1–3]
In line with the Taylor rule framework, this study examines the interactions between the industrial production growth rate, consumer price inflation, short-term interest rates, stock returns and exchange rate volatility by employing Panel Vector Autoregression (PVAR) methodology for 10 OECD countries outside the Euro area (Canada, Czech Republic, Iceland, Israel, Korea, Mexico, Norway, Poland, Sweden and the United Kingdom)
The optimal lag length of the PVAR model was suggested by the Moment and Model Selection Criteria (MMSC), whereupon PVAR model was estimated and variance decompositions (VDCs) and impulse response functions (IRFs) were computed based on a PVAR (1) model
Summary
Introducing financial variables other than exchange rates into the Taylor rule to explore the linkages among economic activity and the financial sector has become familiar102 Trade and Global Market practice in the monetary policy setting [1–3]. The relationship between interest rates and exchange rates is generally explained by the Uncovered Interest Rate Parity (UIP) rule, stating that the difference in interest rates between two countries is equal to the expected change in exchange rates among the countries’ domestic currencies. In this respect, it can be inferred that interest rates may influence the real exchange rates and, the foreign competitiveness of a country. The validity of UIP rule was tested by recent studies made after the 2008–2009 Global Financial Crisis in terms of the possible impacts of monetary policy changes on the rule. The results of [6] found support for both Purchasing Power Parity (PPP) and International Fisher Effect (IFE) theorems
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