Dynamic Effects of Monetary Policy Shocks in Malawi* - African ...

4.2.2. Exchange Rate ModelTaylor (1995), Obstefield and Gertler (1995) and others have drawn attention to monetary policyoperating through exchange rates and net exports. Monetary policy can influence the exchangerate through interest rates, direct intervention in the foreign exchange market or inflationaryexpectations. The changes in the exchange rate, in turn, affect aggregate demand through the costof imported goods, the cost of production and investment, international competitiveness andfirms‟ balance sheets in the case of high-liability dollarisation (Dabla-Norris and Floerkemeier,2005). We investigate the channel by appending the exchange rate variable , to the genericmodel. The vector of endogenous variables in the exchange rate model is, accordingly, presentedas follows:The five variables in the model are output, consumer prices, exchange rates, bank rate andreserve money. In line with system of equations (3.6), the model is identified according to thefollowing scheme:(4.5)(4.6)Figure 4.7 presents impulse responses of exchange rates to own, bank rate and reserve moneyshocks and responses of output and consumer prices to innovations in exchange rates. Amonetary tightening corresponding to an unexpected 2.2 percent increase in the bank rate causesthe domestic currency to appreciate, moving 1.5 percent below baseline after 3 years. Theresponse, however, is insignificant. Contrary to theoretical expectations, the exchange rateresponds to a reserve money shock equivalent to a 7.6 percent sudden increase in reserve moneywith an appreciation, moving 1 percent below baseline after a year. This response is alsoinsignificant. An exchange rate shock equivalent to a depreciation of the domestic currency by5.5 percent, however, attracts significant responses in both consumer prices and output.Consumer prices rise, peaking at 4 percent above baseline after 3 years while output declines inthe first 4 months and rises thereafter, peaking at 4.3 percent above baseline after 4 years.In spite of the weak responses of exchange rates to innovations in monetary policy operatingtargets, Figure 4.8 demonstrates that impulse responses of output and consumer prices to bankrate and reserve money shocks are reasonably different when exchange rates are exogenous towhen they are endogenous, indicating that inclusion of the exchange rate provides importantadditional information to the monetary transmission process.23 | P a g e