A Note on the Volatilities of the Interest Rate and the Exchange Rate Under Different Monetary Policy Instruments : Mexico 1998-2008

To advance our understanding of the mechanisms through which monetary policy affect the economy, in this note we analyze the volatilities of the Mexican short-term interest rate and of the peso-dollar exchange rate under two monetary policy instruments: a non-borrowed reserves requirement target (the “Corto”) and an interest rate target. Using tests for multiple structural changes, we document that both volatilities decreased around the time Banco de Mexico started the transition from the former to the latter. With respect to the volatility transmission from interest rates to exchange rates and vice versa, we find, using a bivariate GARCH model and causality-in-variance tests, bi-causality during the period of the Corto, but no causal relation after the transition started