The Exchange Rate and the Monetary Transmission Mechanism in Germany

For the conduct of monetary policy under floating exchange rates it is important to understand the role of the exchange rate in the monetary transmission mechanism (MTM). The timing and the magnitude of the effects of a change in the exchange rate on output and inflation may be quite different from traditional interest rate channels, thereby affecting optimal policy. In this paper we examine the exchange rate channel in the MTM in Germany by estimating an identified VAR model. Two features of the results are highlighted. The effect of a policy shock on the exchange rate accelerates the pass-through of policy into prices and leads to a different response of the various components of GDP. We then show that these qualitative effects can be duplicated in a general equilibrium model for a semi-small open economy with sticky prices and wages that is calibrated to capture the main features of the German economy.