The Effectiveness of Exchange Rate Targeting as a Monetary Policy Tool at the Zero Lower Bound - The Case of the Czech Republic

Abstract: In November 2013, the Czech economy faced significant deflationary pressure as a consequence of a recessionary European environment. In response, the Czech National Bank decided to depreciate its exchange rate artificially and defend a one-sided exchange rate target of 27 CZK/EUR. The goal is to guide inflation back to target. It is the first central bank to do so and thus provides an example for studying the effectiveness of the policy. We employ a two-stage empirical strategy using a vector autoregressive model: first, we determine the role of the exchange rate for economic easing in the Czech Republic and find that a depreciation supports easing after a shock. At the zero lower bound, this automatic depreciation is constrained. Second, we simulate the development of the Czech economy in the absence of the policy. We find that the policy was effective in averting deflation and raising economic growth. The policy should thus be considered for the monetary policy toolkit of other central banks.