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MONETARY POLICY AND EXCHANGE RATES: A BALANCED TWO-COUNTRY COINTEGRATED VAR MODEL APPROACH

Published online by Cambridge University Press:  20 September 2017

Reinhold Heinlein  and
Hans-Martin Krolzig
Reinhold Heinlein*
Affiliation:
Keele University
Hans-Martin Krolzig
Affiliation:
University of Kent
*
Address correspondence to: Reinhold Heinlein, Keele Management School, Darwin Building DW0.51, Keele University, Staffordshire, ST5 5BG, United Kingdom; e-mail: [email protected].
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Abstract

We study the exchange rate effects of monetary policy in a balanced macroeconometric two-country model for the United States and United Kingdom. In contrast to the empirical literature, which consistently treats the domestic and foreign countries unequally in the modeling process, we consider full model feedback, allowing for a thorough analysis of the system dynamics. The problem of model dimensionality is tackled by invoking the approach by Aoki (1981). Assuming country symmetry in the long run allows to decouple the two-country macrodynamics of country averages and differences such that the cointegration analysis can be applied to smaller systems. Second, the econometric modeling is general-to-specific, a graph-theoretic approach for the contemporaneous effects combined with automatic general-to-specific model selection. We find delayed overshooting of the exchange rate in the case of a Bank of England monetary shock but instantaneous response to a Fed shock. Altogether the response is more pronounced in the former case.

Keywords

Two-Country ModelCointegrationMonetary PolicyExchange Rates
Type
Articles
Information
Macroeconomic Dynamics , Volume 23 , Issue 5 , July 2019 , pp. 1838 - 1874
Copyright
Copyright © Cambridge University Press 2017 

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Footnotes

We are grateful to William A. Barnett and two anonymous referees, to Ralf Brüggemann, Sascha Buetzer, Miguel León-Ledesma, Helmut Lütkepohl, and the seminar audiences at Kent, University of Konstanz, DIW Macroeconometric Workshop 2011, Berlin, SNDE Symposium 2012, Istanbul, the ICMAIF 2012, Rethymno, the VfS Congress 2012, Göttingen, the RCEA Time Series Workshop 2013, Rimini and the IAAE 2014, London. The usual disclaimer applies.

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