Identifying Monetary Policy in a Small Open Economy under Flexible Exchange Rates

This 1997 Journal of Monetary Economics paper by David Cushman and Tao Zha addresses the “exchange rate puzzle” and “price puzzle” that plague conventional recursive (Choleski) VAR studies of monetary policy in small open economies – where a contractionary domestic interest-rate shock perversely depreciates the currency and raises prices – by arguing these puzzles “derive from an identification of monetary policy that is inappropriate for such economies,” specifically the recursive ordering’s implicit assumption that the central bank cannot respond contemporaneously to the exchange rate, which is inconsistent with how a small-open-economy central bank like the Bank of Canada actually behaves. Using monthly Canada-US data from 1974-1993 (chosen to avoid the 1973 oil shock and the pre-float period) with 12 lags, the authors estimate a non-recursive structural VAR with block exogeneity, treating the US block (output, prices, the federal funds rate, and a world commodity price index) as exogenous to Canada while specifying the Canadian block’s contemporaneous structure across three sectors: a money market (a money-demand equation plus a policy reaction function that lets policy respond within the month to the exchange rate, the Canadian money stock, the foreign interest rate, and commodity prices), an information market (an exchange-rate equation responding to all eleven contemporaneous variables), and a recursively-ordered production sector (imports, exports, output, prices) excluded from contemporaneous foreign and financial influences. Estimated by maximum likelihood with Monte Carlo error bands (Zha 1996 method) and passing a model-stability test (chi-square(364) = 346.1), the identification eliminates both puzzles: a contractionary monetary policy shock produces an immediate, persistent decline in M1, an immediate and significant appreciation of the Canadian dollar lasting about 12 months, only a brief and small rise in the nominal interest rate, and a gradual, non-puzzling decline in the price level. Transmission operates primarily through the exchange rate rather than the interest rate – in contrast to the strong interest-rate effects found in US studies such as Gordon and Leeper (1994) – with a J-curve pattern in the trade balance (imports down roughly 0.5% by month 4) and approximate uncovered interest parity (UIP deviations significant for only about 4 months). Forecast-error variance decompositions show monetary policy shocks explain a small share of Canadian output variance – about 1.00% at 12 months, no more than 2.75% at any horizon up to 6 months – with the production and information sectors dominating in the first few months and foreign shocks becoming dominant after 12 months (roughly 72-74% of output variance at 12, 24, and 48 months), a result the authors caution does not imply that endogenous monetary policy itself is ineffective.

David O. Cushman | Macro Paper Warehouse

Identifying Monetary Policy in a Small Open Economy under Flexible Exchange Rates