Monetary policy and the exchange rate: Evidence from a two-country model

We present a two-country structural VAR model of monetary policy and the exchange rate for the US and Australia that allows us to identify both US and Australian monetary policy innovations. A key finding is the asymmetry in the effects of these innovations on the exchange rate, both the nature of the response and their relative importance. A second key finding is evidence of exchange rate disconnect: innovations to the real economy explain little of the variation in the exchange rate. We also consider the effects of exchange rate innovations and find evidence of slow but substantial pass through to domestic prices with evidence that the response of monetary policy is at least partially responsible for the slow adjustment.