Inflation, Monetary Transparency, and G3 Exchange Rate Volatility

Abstract

There is a tension between pre-float instincts that a more disciplined monetary policy should diminish exchange rate volatility with the apparent reality that macroeconomic fundamentals do not drive G3 exchange rates in the short-run. The recent movement towards greater transparency in monetary policymaking may partially reconcile this conflict. This possibility depends on the extent to which domestic inflation and interest rate surprises contribute to short-run volatility in G3 exchange rates. These are precisely the type of shocks which should diminish in frequency and effect as monetary transparency increases. If monetary transparency is effective, variations over time in American, German, and Japanese central bank institutions and behavior should match up with the timing of these shocks and the magnitude of their impact on bilateral exchange rates. We set out a simple model of the implications of different monetary regimes for the response of inflation, interest rates, and exchange rates to inflation surprises. We then develop an operational measure of central bank transparency, and apply it to the history of the Bank of Japan, the Bundesbank, and the Federal Reserve in the period 1975-1998, finding significant shifts in institutional transparency for the Federal Reserve and for the Bank of Japan in the late 1980s. To test for a relationship between transparency and volatility, we estimate and analyze structural VAR models of relative interest rates, inflation rates, and exchange rates for the DMB- and DM-$. An assessment of the importance of domestic inflation and interest rate shocks to G3 exchange rate volatility indicates that increases in central bank transparency could meaningfully but not totally diminish that volatility.