Does the Exchange Rate Respond to Monetary Policy in Mexico? Solving an Exchange Rate Puzzle in Emerging Markets

This paper argues that the null or weak response of emerging market currencies to domestic monetary policy documented in the literature is the result of wide event windows. An event study with intraday data for Mexico shows that an unanticipated tightening appreciates the currency and flattens the yield curve, consistent with the evidence for advanced economies. With daily event windows, however, only the yield curve responds to monetary policy. Noise in daily exchange rate returns explains the lack of response of the currency. Such noise gives rise to a bias that declines after controlling for potential omitted variables.

Automated summary

This paper argues that the lack or weak response of emerging market currencies to domestic monetary policy is due to wide event windows. An event study with intraday data for Mexico shows that an unanticipated tightening leads to currency appreciation and a flattened yield curve, consistent with evidence for advanced economies. However, with daily event windows, only the yield curve responds to monetary policy. The lack of currency response is explained by noise in daily exchange rate returns, which decreases after controlling for potential omitted variables.