From Announcement to Adjustment: Exchange Rate Responses to U.S. Stimulus Announcements and the Roles of Trade and Financial Channels

Abstract

This paper examines the effect of stimulus announcements on exchange rates. To do this, I first utilize a vector autoregression (VAR) to study the exchange rate movement over a longer period of time. To then narrow down the effect, I use a narrative high frequency approach to isolate the policy shock by narrowing down the event window period to analyze exchange rate movements following a stimulus announcement. The market reaction to the information shock could be understood by two mechanisms. The first is the trade channel, which suggests that when households receive stimulus payments, their demand for goods, including imported goods, increases. Therefore, this increases the demand for foreign currencies, which depreciates the dollar. The second is through the financial channel, which suggests that increased government borrowing to finance this expenditure may push interest rates up, which causes increased investment in US assets, therefore, causing the dollar to appreciate. The results show consistent support for the trade channel. In both the high frequency event studies and VARs, the dollar depreciates following the stimulus announcement. The magnitude of these effects is larger for high trading partners than low trading partners, thus, providing strong support for the trade channel as the primary mechanism driving the movement in exchange rates. The only deviation in dollar direction occurs during the 2021 Consolidated Appropriations Act, where the dollar appreciates instead. This anomaly highlights how political uncertainty can dampen the market response. On the other hand, we see little evidence for the financial channel.