By Andrew Brigden, Ben Martin and Chris Salmon of the Bank’s Monetary Assessment and Strategy Division.
The monetary authorities of a country with a floating exchange rate, such as the United Kingdom, face the important and difficult issue of how to respond to exchange rate changes. As the price of one country’s money in terms of another country’s money, a floating exchange rate may change in response to developments either at home or abroad. The implications for monetary conditions, and so for the setting of national monetary policies, depend on the underlying causes. This article describes one approach, based on the uncovered interest rate parity (UIP) condition, used by the Bank to assess the contribution of monetary policy news to exchange rate developments.
The first section of the article discusses the relationship between the exchange rate and monetary policy in more detail. The second section describes techniques that have been used in the past to try to identify the underlying causes of exchange rate developments. The third section sets out in detail how the UIP condition can be adapted to provide an estimate of the contribution of news about monetary policy to exchange rate changes. The fourth section illustrates the potential use of this UIP decomposition with some case studies. The article concludes by assessing this technique, including some of its potential pitfalls.