Working Paper: CEPR ID: DP14324
Authors: Luca Dedola; Georgios Georgiadis; Johannes Gräb; Arnaud Mehl
Abstract: We estimate the effects of quantitative easing (QE) measures by the ECB and the Federal Reserve on the US dollar-euro exchange rate at frequencies and horizons relevant for policymakers. To do so, we derive a theoretically-consistent local projection regression equation from the standard asset pricing formulation of exchange rate determination. We then proxy unobserved QE shocks by future changes in the relative size of central banks’ balance sheets, which we instrument with QE announcements in two-stage least squares regressions in order to account for their endogeneity. We find that QE measures have large and persistent effects on the exchange rate. The typical ECB or Federal Reserve expansionary QE announcement in our sample resulted in an increase in the relative balance sheet of about 20% and, in turn, in a persistent exchange rate depreciation of around 7%. Regarding transmission channels, we find that a relative QE shock that expands the ECB’s balance sheet relative to that of the Federal Reserve depreciates the euro against the US dollar by reducing euro-dollar short-term money market rate differentials, by widening the cross-currency basis and by eliciting adjustments in “residual” deviations from interest parity. Changes in the expectations about the future monetary policy stance, reflecting the “signalling'” channel of QE, also contribute to the exchange rate response to QE shocks.
Keywords: QE; dynamic effects; signaling channel of QE; CIP deviations
JEL Codes: F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| QE announcement by ECB or Federal Reserve (E52) | increase in relative balance sheet (G32) |
| increase in relative balance sheet (G32) | persistent exchange rate depreciation (F31) |
| relative QE shock (ECB's balance sheet expansion) (E49) | depreciation of euro against dollar (F31) |
| relative QE shock (C54) | reduces euro-dollar short-term money market rate differentials (E43) |
| relative QE shock (C54) | widens cross-currency basis (F31) |
| relative QE shock (C54) | adjustments in residual deviations from interest parity (F31) |
| changes in expectations about future monetary policy (E52) | exchange rate response to QE shocks (F31) |