Real Exchange Rate and Implications for Monetary Policy

Abstract

This chapter determines the implications of real exchange rate shocks on the repo rate adjustment and inflation dynamics. This chapter, examines the indirect role of exports in transmitting exchange rate shocks to policy rate and the relevance of policy uncertainty channel. Evidence based on historical decomposition reveals that during 2007 and 2009, the REER depreciation contributed to the evolution of inflationary pressures. The massive REER appreciation in 2009 contributed to the decline in inflation. Despite the persistent depreciation in the REER since 2011, there is no evidence of persistent REER depreciation effects placing upward pressure on inflation until recently in 2013Q1. Moreover, the monetary policy stance was still accommodative in 2013Q1–Q3, even though the REER depreciation contribution to inflation was just beginning to be positive. Is the exchange rate a shock absorber or an independent source of shocks itself? Evidence based on a historical contributions approach suggests that the fundamentals as captured by the variables in the model seem to explain large movements in the REER. Evidence presented in this chapter suggests that the exchange rate is a shock absorber to changes in fundamentals. What can be inferred about the role of EU economic growth shocks on the REER movements? Evidence shows that after shutting off the contributions from own REER contributions and the EU economic growth, the massive REER appreciation in 2009 can be partly attributed to the policies aimed at dealing with external growth developments and less to due to the REER own movements. This suggests that slow EU economic growth and the ECB policy interventions aimed at averting the deflationary pressures will continue to impact REER changes. Foreign policy shocks can result in the appreciation of the REER thus compromising the competitiveness of the domestic economy. However, the benefit to the economy may be transmitted through the positive effects on exerting downward pressure on inflation. In monetary policy terms, this can support the gradual policy tightening and normalisation cycle.