The Legacy of CNB’s Exchange Rate Commitment

• Thesis title in Czech: Dědictví českého kurzového závazku
• Thesis title in English: The Legacy of CNB’s Exchange Rate Commitment
• English key words: monetary policy, exchange rate policy, long-run effects
• Academic year of topic announcement: 2022/2023
• Thesis type: diploma thesis
• Thesis language: angličtina
• Department: Institute of Economic Studies (23-IES)
• Supervisor: PhDr. Jaromír Baxa, Ph.D.
• Author: hidden - assigned by the advisor
• Date of registration: 27.06.2023
• Date of assignment: 27.06.2023

Guidelines

Motivation:
On 7th November 2013, Czech National Bank introduced its unconventional monetary policy tool – the exchange rate commitment. This measure meant a one-sided peg of the exchange rate to its minimal floor of 27 CZK/EUR, which essentially caused depreciation of the exchange rate by about 7%. The reason why CNB pursued this operation was to prevent Czech economy entering deflation under unusual circumstances of zero lower bound on interest rates. This intervention was intended to be brief, lasting only a few quarters and ending in 2015, the year when inflation was expected to reach its target (Hampl, 2017). However, it took approximately 3,5 years for inflation to restore, and the exchange rate commitment ended on 6th April 2017.

There is a body of literature evaluating the commitment's short-term impact on inflation and other economic variables. For instance, Bruha and Tonner (2017) note that the floor prevented inflation from being negative while observing a positive relationship with inflation and other macroeconomic variables. The effects are statistically strongly significant regarding core inflation. Authors apply two distinct sets of approaches: a model-based approach using g3 DSGE model, which is the official forecasting model of CNB, and an empirical approach applying synthetic control method and its generalised version. The results are consistent across the approaches employed. Question why inflation remained low longer than expected is being answered by Baxa and Sestorad (2019), who find evidence in favour of long-term changes in the Czech economy compared to a one-off shock. According to their study, the effect of the commitment was not surprising since the exchange rate pass-through was gradually decreasing for inflation and increasing in the case of output. However, based on their findings, the CNB's intervention likely increased inflation and output growth, albeit only somewhat in the case of the former. Similar pattern where output growth was stimulated more than inflation is also found by Opatrny (2016).

Originally, the exchange rate commitment was to be implemented before November 2013. Only at that board meeting, the exchange rate commitment came into force in ratio 4:3. One might argue that such a narrow margin may reflect disagreements over its appropriateness, which we may trace even to the present. For instance, a member of the board Eva Zamrazilova referred to it as one of the biggest monetary policy mistakes and that its legacy in the Czech economy can be felt even nowadays. Martin Fassmann, an economist, went even farther in 2023 and suggested that one of the possible reasons for the current high inflation rate could be the exchange rate commitment. In similar spirit, on the board meeting of CNB on 4th August 2022, two bank board members suggested that the present inflation is among other things caused by the too loose monetary policy in the previous decade. It was also mentioned that the commitment expanded the banking sector's balance sheet, which has partly contributed to inflation we observe just less than 10 years after the exchange rate commitment started. This was negated by another board member referring to the case of Switzerland that underwent similar treatment but had one the lowest inflation rates in Europe in 2022. This claim implies that the commitment only had short-term effects on the economy. However, academic literature also suggests that monetary policy can have an impact on economic variables across longer time horizons than is typically thought. For instance, Jorda et al. (2020) estimated a decline of 4.68% in real output in the long run as a response to 1% shock to nominal interest rates. The long run money neutrality was already tested before by Bernanke and Mihov (1998). While they were not able to reject the neutrality theorem, they did demonstrate that the economy adjusts slowly and takes more than ten years to recover from a monetary shock.

Empirically, the exchange rate commitment was somewhat successful in stimulating inflation as promised. However, all studies only use data covering short-term horizon, while some economists argue that the commitment might have partly contributed to the current episode of inflation and thus having long-term impact. In light of the body of literature advocating long-term effects of monetary policy, it might be important to evaluate the CNB’s exchange rate commitment and determine how it relates to current inflation, nearly 10 years after the commitment was put in place.

Hypotheses:
1. Hypothesis #1: The CNB’s exchange rate commitment is positively related to current inflation.
2. Hypothesis #2: The CNB’s exchange rate commitment is positively related to current states of other macroeconomic variables, such as unemployment and output growth.
3. Hypothesis #3: The roots of the current inflation are related to limited response of the central bank to recent shocks rather than to policies implemented a decade ago.

Expected Contribution:
The goal of this thesis is to empirically assess whether monetary policy can have long-term effects. Specifically, this hypothesis is tested using the experience of the exchange rate commitment introduced in the Czech Republic, which is regarded as a prototype for a small open economy. The contribution of the thesis lies in understanding the effects of monetary policy while challenging the prevalent paradigm of short-term effects and long-term money neutrality. Should the commitment or FX interventions occur again, the findings may have potential implications for better policy decisions. Furthermore, the results could shape public debate on the long-term effects of the exchange rate commitment, including its effects on inflation and other macroeconomic factors. Simultaneously, evidence on potential cause of the current high inflation could also be provided.

References

Core Bibliography:

ABADIE, A., A. DIAMOND, AND J. HAINMUELLER (2010): “Synthetic Control Methods for
Comparative Case Studies: Estimating the Effect of California’s Tobacco Control Program.”
Journal of the American Statistical Association, 105(490):493–505.

BAXA, J. AND T. SESTORAD (2019): “The Czech Exchange Rate Floor: Depreciation without Inflation?” CNB Working Paper Series 1/2019, Czech National Bank

BERNANKE, B. S., AND I. MIHOV (1998): “The liquidity effect and long-run neutrality.” Carnegie-
Rochester Conference Series on Public Policy 49(1): 149–194.

BRUHA, J. AND J. TONNER (2017): “An Exchange Rate Floor as an Instrument of Monetary Policy:
An Ex-post Assessment of the Czech Experience.” CNB Working Paper Series 4/2017,
Czech National Bank

CHERNOZHUKOV, V., WÜTHRICH, K. AND ZHU, Y. (2021): “An exact and robust conformal inference method for counterfactual and synthetic controls.” Journal of the American Statistical Association, 2021, 116.536: 1849-1864.

DOUDCHENKO, N. AND G. IMBENS (2016): “Balancing, Regression, Difference-in-Difference
and Synthetic Control Methods: A Synthesis.” NBER Working Paper 22791, NBER.

HAMPL, M. (2017): “CNB’s New Forecast (Inflation Report II/2017).” Meeting with Analysts
(Prague, May 5, 2017), Czech National Bank: (https://www.cnb.cz/export/sites/cnb/en/monetary-policy/.galleries/forecast/analysts_meetings/download/analysts_2017_II.pdf) [Retrieved on June 18, 2023]

JORDA, O., SINGH, S. R., AND TAYLOR, A. M. (2020): “The Long-Run Effects of Monetary Policy.” NBER Working Paper 26666, NBER

OPATRNY, M. (2016): “Quantifying the Effects of the CNB’s Exchange Rate Commitment: A Synthetic
Control Method Approach.” Working Papers, Institute of Economic Studies, Charles
University.

XU, Y. (2015): “Generalized Synthetic Control Method for Causal Inference with Time-Series
Cross-Sectional Data.” MIT Political Science Department Research Paper 2015-1, MIT

Preliminary scope of work

Methodology:
To test the hypotheses, I will follow the paper by Bruha and Tonner (2017). Specifically, I will employ two empirical approaches – synthetic control method and generalized synthetic control method. These methods were developed by Abadie et al. (2010) and Xu (2015) respectively, with subsequent developments of the former by Doudchenko and Imbens (2016). Additionally, I will consider the more recent extensions to the synthetic control method by Chernozhukov et al. (2021) who provide methods for robust inference. All methods allow for testing the effect of the commitment compared to an alternative development without it. The main source of the data is Eurostat since it credibly stores economic data for European countries. The choice of the variables is motivated by Bruha and Tonner (2017). In addition, I will also consider a housing market indicator as another variable.

Outline:
1. Introduction: I introduce the topic and highlight the contribution of the thesis.
2. Literature Review: I review related literature on exchange rate commitment, long-term effects of monetary policy etc.
3. Data: I elaborate on chosen variables, their data sources, and descriptive statistics.
4. Methodology: I describe the econometric framework and methodological approach of SCM.
5. Results: I provide and discuss results, evaluate hypotheses, and conduct robustness tests.
6. Conclusion: I summarize the findings and elaborate on policy implications and further research.