The link between exchange rates and monetary policy
A new working paper from the Bank of Canada shows that aggressive monetary policy decisions have contributed to a decline in the exchange rate pass-through (ERPT) effect.
Defining pass through in the context of a reduced-form Phillips-curve equation and using an open economy dynamic stochastic general equilibrium (DSGE) model, the paper finds evidence of a strong negative relationship between monetary policy aggressiveness and the ERPT in Canada.
Small changes in policy can have a pronounced effect on the relationship between prices and the exchange rate when mark-up shocks are present, the paper argues. It finds that aggressive policy has reduced pass through in Canada by about 50% compared to the level before 1984.
The paper, entitled ‘Exchange rate pass-through and monetary policy: how strong is the link?' was published by the central bank on 16 October.
Click here to read the full paper
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