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Monetary Policy Divergence, Net Capital Flows, and Exchange Rates: Accounting for Endogenous Policy Responses

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Abstract
This paper measures the effect of monetary tightening in key advanced economies on net capital flows and exchange rates around the world. Measuring this effect is complicated by the fact that the domestic monetary policies of affected economies respond endogenously to the foreign tightening shock. Using a structural VAR framework with quarterly panel data we estimate the impulse responses of domestic policy variables and net capital flows to a foreign monetary tightening shock. We find that the endogenous responses of domestic monetary policy depends on each economy?s capital account openness and exchange rate regime. We develop a method to plot counter-factual impulse responses for net capital outflows under the assumption that domestic interest rates are held constant despite foreign monetary tightening. Our results suggests that failing to account for the endogenous response of domestic monetary policy biases down the estimated elasticity of net capital flows to foreign interest rates by as much as for floaters and for peggers with open capital accounts.

Suggested Citation

  • J. Scott Davis & Andrei Zlate, 2017. "Monetary Policy Divergence, Net Capital Flows, and Exchange Rates: Accounting for Endogenous Policy Responses," Globalization Institute Working Papers 328, Federal Reserve Bank of Dallas.
    • Handle: RePEc:fip:feddgw:328
    DOI: 10.24149/gwp328
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    References listed on IDEAS

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    Cited by:

    1. Chinn, Menzie & Devereux, Michael B. & Kollmann, Robert, 2018. "International Financial Integration in a Changing Policy Context – the End of an Era?," MPRA Paper 90400, University Library of Munich, Germany.

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    More about this item

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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