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Seminar on Banco de la Republica�s Ensayos de Pol�tica Econ�mica
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Risk premium shocks, monetary policy
and exchange rate pass-through in the
Czech Republic, Hungary and Poland
Balázs Vonnák
Magyar Nemzeti Bank
Motivation
Transition countries’ exchange rates
are sensitive to changes in global
investors’ risk sentiment
Small open economies: CPI is
sensitive to the exchange rate
What should monetary policy do in
the presence of exchange rate
shocks?
Vonnák: risk premium shocks and exchange rate pass-through 2 / 30
Results
Interest rate may not be an efficient
tool to fight against exchange rate
shocks
Stable and low inflation dampens the
exchange rate pass-through helping
ignore risk premium shocks
Vonnák: risk premium shocks and exchange rate pass-through 3 / 30
Outline
The model
Impulse responses
Exchange rate pass-through
Conclusions
Vonnák: risk premium shocks and exchange rate pass-through 4 / 30
The model
VAR
Identification of structural shocks by
combination of contemporaneous zero
and sign restrictions
Czech Republic, Hungary, Poland
Control group: Canada, Sweden and
the UK
Vonnák: risk premium shocks and exchange rate pass-through 5 / 30
The model: VAR (1)
Variables:
industrial production
consumer prices
short-term nominal interest rate
nominal effective exchange rate
Contemporaneous and 1 lagged
foreign variables as exogenous
Vonnák: risk premium shocks and exchange rate pass-through 6 / 30
The model: VAR (2)
Monthly series
Typically from 1995-8:M1 to
2006:M12
As many lags as necessary for white
noise residuals (3-7)
Vonnák: risk premium shocks and exchange rate pass-through 7 / 30
The model: identification (1)
Only two shocks:
monetary policy
risk premium (UIP, exchange rate shock)
The rest is left unidentified
Why not Cholesky: simultaneous
effect on interest rate and exchange
rate of both shocks
Vonnák: risk premium shocks and exchange rate pass-through 8 / 30
The model: identification (2)
Assumptions:
The shocks have no immediate effect on
neither production nor prices
Unexpected monetary contraction
appreciates the currency and keeps
interest rate higher for 12 months
Negative risk premium shock depreciates
the currency and keeps interest rate
higher for 12 months
Vonnák: risk premium shocks and exchange rate pass-through 9 / 30
The model: implementation
Variables in level
Bayesian approach a la Uhlig (2005)
Medians and in some cases the 68
and 95 percent of the posterior
distribution reported
I checked alternative measures for
„mean” as well, but they did not change
the main conclusions
Vonnák: risk premium shocks and exchange rate pass-through 10 / 30
Impulse responses
IRFs are often „insignificant”
The identification scheme seems to
work:
Almost no exchange rate puzzles
Similar results for CEE countries
Differences between transition and
developed countries
Sweden and Canada, monetary policy
shock: price puzzle
Vonnák: risk premium shocks and exchange rate pass-through 11 / 30
Response of interest rate to a
monetary policy shock
Czech Republic Hungary
0.5% 0.5%
0.4% 0.4%
0.3% 0.3%
0.2% 0.2%
0.1% 0.1%
0.0% 0.0%
-0.1% -0.1%
1 13 25 37 49 1 13 25 37 49
month month
Poland United Kingdom
0.5% 0.5%
0.4% 0.4%
0.3% 0.3%
0.2% 0.2%
0.1% 0.1%
0.0% 0.0%
-0.1% -0.1%
1 13 25 37 49 1 13 25 37 49
month month
Vonnák: risk premium shocks and exchange rate pass-through 12 / 30
Response of exchange rate to a
monetary policy shock
Czech Republic Hungary
0.5% 0.5%
0.0% 0.0%
-0.5% -0.5%
-1.0% -1.0%
-1.5% -1.5%
-2.0% -2.0%
1 13 25 37 49 1 13 25 37 49
month month
Poland United Kingdom
0.5% 0.5%
0.0% 0.0%
-0.5% -0.5%
-1.0% -1.0%
-1.5% -1.5%
-2.0% -2.0%
1 13 25 37 49 1 13 25 37 49
month month
Vonnák: risk premium shocks and exchange rate pass-through 13 / 30
Response of production to a
monetary policy shock
Czech Republic Hungary
0.4% 0.4%
0.2% 0.2%
0.0% 0.0%
-0.2% -0.2%
-0.4% -0.4%
-0.6% -0.6%
1 13 25 37 49 1 13 25 37 49
month month
Poland United Kingdom
0.4% 0.4%
0.2% 0.2%
0.0% 0.0%
-0.2% -0.2%
-0.4% -0.4%
-0.6% -0.6%
1 13 25 37 49 1 13 25 37 49
month month
Vonnák: risk premium shocks and exchange rate pass-through 14 / 30
Response of consumer prices to
a monetary policy shock
Czech Republic Hungary
0.2% 0.2%
0.1% 0.1%
0.0% 0.0%
-0.1% -0.1%
-0.2% -0.2%
-0.3% -0.3%
-0.4% -0.4%
1 13 25 37 49 1 13 25 37 49
month month
Poland United Kingdom
0.2% 0.2%
0.1% 0.1%
0.0% 0.0%
-0.1% -0.1%
-0.2% -0.2%
-0.3% -0.3%
-0.4% -0.4%
1 13 25 37 49 1 13 25 37 49
month month
Vonnák: risk premium shocks and exchange rate pass-through 15 / 30
Impulse responses to monetary
policy shocks
They look reasonable
but: price puzzle in Canada and Sweden
(shown in the paper, not here)
When shocks are identified jointly,
nice results for one shock increase
the plausibility of others
because of orthogonality
Vonnák: risk premium shocks and exchange rate pass-through 16 / 30
Response of interest rate to a
risk premium shock
Czech Republic Hungary
0.5% 0.5%
0.4% 0.4%
0.3% 0.3%
0.2% 0.2%
0.1% 0.1%
0.0% 0.0%
-0.1% -0.1%
-0.2% -0.2%
1 13 25 37 49 1 13 25 37 49
month month
Poland United Kingdom
0.5% 0.5%
0.4% 0.4%
0.3% 0.3%
0.2% 0.2%
0.1% 0.1%
0.0% 0.0%
-0.1% -0.1%
-0.2% -0.2%
1 13 25 37 49 1 13 25 37 49
month month
Vonnák: risk premium shocks and exchange rate pass-through 17 / 30
Response of exchange rate to a
risk premium shock
Czech Republic Hungary
2.5% 2.5%
2.0% 2.0%
1.5% 1.5%
1.0% 1.0%
0.5% 0.5%
0.0% 0.0%
-0.5% -0.5%
1 13 25 37 49 1 13 25 37 49
month month
Poland United Kingdom
2.5% 2.5%
2.0% 2.0%
1.5% 1.5%
1.0% 1.0%
0.5% 0.5%
0.0% 0.0%
-0.5% -0.5%
1 13 25 37 49 1 13 25 37 49
month month
Vonnák: risk premium shocks and exchange rate pass-through 18 / 30
Response of production to a
risk premium shock
Czech Republic Hungary
1.0% 1.0%
0.5% 0.5%
0.0% 0.0%
-0.5% -0.5%
1 13 25 37 49 1 13 25 37 49
month month
Poland United Kingdom
1.0% 1.0%
0.5% 0.5%
0.0% 0.0%
-0.5% -0.5%
1 13 25 37 49 1 13 25 37 49
month month
Vonnák: risk premium shocks and exchange rate pass-through 19 / 30
Response of consumer prices to
a risk premium shock
Czech Republic Hungary
0.3% 0.3%
0.2% 0.2%
0.1% 0.1%
0.0% 0.0%
-0.1% -0.1%
1 13 25 37 49 1 13 25 37 49
month month
Poland United Kingdom
0.3% 0.3%
0.2% 0.2%
0.1% 0.1%
0.0% 0.0%
-0.1% -0.1%
1 13 25 37 49 1 13 25 37 49
month month
Vonnák: risk premium shocks and exchange rate pass-through 20 / 30
Impulse responses: findings (1)
Hungarian interest rate reacts quickly
and sharply to risk premium shocks…
but not sharply or permanently
enough to stabilize the exchange
rate,…
therefore the effect on prices is
roughly the same as in other
countries
Vonnák: risk premium shocks and exchange rate pass-through 21 / 30
Impulse responses: findings (2)
Reason: the size of the interest rate change
is only the tenth of the change in expected
excess return
Annualized predictable excess return:
PERt = it − 4 * (st +3 − st )
Assumption:
required excess return is determined by the
investor
central bank splits into interest rate and
exchange rate
Vonnák: risk premium shocks and exchange rate pass-through 22 / 30
Impulse responses: findings (3)
Predictable excess return after a risk premium shock
5
4
3 HU CZ
percent
PL UK
2
1
0
-1
1 13 25
month
Vonnák: risk premium shocks and exchange rate pass-through 23 / 30
Exchange rate pass-through
Two measures of pass-through:
shocks are normalized so that the
exchange rate depreciates in the first
year by 1 percent on average
sequence of shocks are generated so
that the exchange rate depreciates by 1
percent permanently
The pass-through is defined as the
dynamic response of consumer prices
Vonnák: risk premium shocks and exchange rate pass-through 24 / 30
Exchange rate pass-through:
transitory risk premium shock
0.4
HU
0.3 CZ
PL
UK
SW
0.2
CA
percent
0.1
0
-0.1
1 13 25 37 49
month
Vonnák: risk premium shocks and exchange rate pass-through 25 / 30
Exchange rate pass-through:
permanent risk premium shock
0.4
0.3
0.2
percent
0.1
0.0
HU CZ PL UK SW CA
-0.1
1 13 25 37 49
month
Vonnák: risk premium shocks and exchange rate pass-through 26 / 30
Exchange rate pass-through:
findings and explanation
In developed countries the pass-
through is lower
Taylor (2000) explains the observed
decline in pass-through of cost shocks
to consumer prices by lower inflation,
more anchored expectations
little incentive for repricing when
nominal shocks are short-lived
Vonnák: risk premium shocks and exchange rate pass-through 27 / 30
Annual inflation rates
0.35
0.3
CA
CZ
0.25 HU
PL
0.2 SW
UK
percent
0.15
0.1
0.05
0
-0.05
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Vonnák: risk premium shocks and exchange rate pass-through 28 / 30
Conclusions
Interest rate may not be an efficient
tool to fight against exchange rate
shocks
Stable and low inflation dampens the
exchange rate pass-through helping
ignore risk premium shocks
Vonnák: risk premium shocks and exchange rate pass-through 29 / 30
Thank you for the attention
Vonnák: risk premium shocks and exchange rate pass-through 30 / 30
