Modelling the Exchange Rate: Evidence from the Impacts of Quantitative Easing in Sweden

Abstract: Quantitative easing, the unconventional monetary policy measure used by many central banks to combat low inflation when interest rates are at the lower bound, has shown to be an effective tool for depreciating the domestic currency. Although the exchange rate is of particular importance in a small open economy as it directly impacts inflation dynamics,trade competitiveness and plays a substantial role in shaping monetary policy, few papers have investigated how the depreciating effect of QE to the exchange rate works. In this thesis, we employ a Bayesian vector autoregressive model (BVAR) and find that the Swedish Riksbank's quantitative easing (QE) programme between 2015-2017 depreciated the domestic currency to a larger extent than previous research has shown, even when accounting for spillovers from the European Central Bank's (ECB) QE during the same period. The depreciation is robust to various potential omitted variables and priors,suggesting the Riksbank's QE may have had greater consequences for the domestic exchange rate than initially thought. The greater persistence and magnitude in the depreciation can partly be attributed to the inclusion of the US short rate in the model, suggesting that short-term market sentiment and influence from the US play a considerable role in Swedish economy. As there isn't enough research on the krona in a VAR-setting to make a comparison, this result can be seen as a suggestion to account for US short-term influences when modelling the Swedish exchange rate. By using a two-step approach inspired by previous literature, we also find novel evidence of how quantitative easing in Sweden transmits to depreciate the exchange rate. Support is found for the signalling and portfolio channel, but not for the confidence channel, suggesting that quantitative easing depreciates the exchange rate by reducing the market's interest rate expectations and as investors substitute Swedish bonds for higher yielding foreign assets, but not through increasing confidence in the market.