Monetary Policy Shocks in a Tri-Polar Model of Foreign Exchange

Abstract

This paper investigates effects of third-currency monetary policy shocks on exchange rates. For this purpose we setup a structural VAR model containing the exchange rates of the three major currencies – the U.S. dollar, the euro and the Japanese yen – and short-term interest rates on the three currencies. In addition, we include the medium-term interest rates and price levels as control variables. Long-run restrictions in accord with tested hypotheses and the existing literature are used to identify the structural VAR. The impulse response analysis of the co- integrated VAR reveals that third-currency monetary policy shocks not only significantly impact on the considered exchange rates but their impacts are comparable to those of MP shocks associated with the quoted currencies in terms of their magnitude.Exchange Rates, Currency Substitution, Third-Currency Effects, SVAR