Exchange rate pass-through, monetary policy, and variability of exchange rates

We document that contribution of identified US monetary shock to exchange rate variability differs across currencies and is inversely related to the degree of a country’s US dollar exchange rate pass-through into import prices. We explore this empirical pattern under the assumption that each central bank, when choosing its monetary policy, takes into account in which currency its country’s exports and imports are denominated. The choice of imports invoicing currency will affect both the degree of exchange rate pass-through and the monetary policy response. Different shape of monetary policy reaction function will result in different contribution of monetary shocks to the exchange rate dynamics. We illustrate this mechanism using a simple general equilibrium model.