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Monetary policy and exchange rate overshooting: Dornbusch was right after all

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  • Bjørnland, Hilde C.

Abstract

Dornbusch's exchange rate overshooting hypothesis is a central building block in international macroeconomics. Yet, empirical studies of monetary policy have typically found exchange rate effects that are inconsistent with overshooting. This puzzling result has been viewed by some researchers as a "stylized fact" to be reckoned with in policy modelling. However, many of these studies, in particular those using vector autoregressive (VARs) approaches, have disregarded the strong contemporaneous interaction between monetary policy and exchange rate movements by placing zero restrictions on them. In contrast, we achieve identification by imposing a long-run neutrality restriction on the real exchange rate, thereby allowing for contemporaneous interaction between the interest rate and the exchange rate. In a study of four open economies, we find that the puzzles disappear. In particular, a contractionary monetary policy shock has a strong effect on the exchange rate, which appreciates on impact. The maximum effect occurs within 1-2 quarters, and the exchange rate thereafter gradually depreciates to baseline, consistent with the Dornbusch overshooting hypothesis and with few exceptions consistent with uncovered interest parity (UIP).

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 79 (2009)
Issue (Month): 1 (September)
Pages: 64-77

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Handle: RePEc:eee:inecon:v:79:y:2009:i:1:p:64-77

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Web page: http://www.elsevier.com/locate/inca/505552

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Keywords: Exchange rate Uncovered interest parity (UIP) Dornbusch overshooting Monetary policy Structural vector autoregressive (VAR);

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Cited by:
  1. Charles Engel, 2011. "The Real Exchange Rate, Real Interest Rates, and the Risk Premium," NBER Working Papers 17116, National Bureau of Economic Research, Inc.
  2. Vithessonthi, Chaiporn, 2014. "Monetary policy and the first- and second-moment exchange rate change during the global financial crisis: Evidence from Thailand," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 29(C), pages 170-194.
  3. Cover, James P. & Mallick, Sushanta K., 2012. "Identifying sources of macroeconomic and exchange rate fluctuations in the UK," Journal of International Money and Finance, Elsevier, vol. 31(6), pages 1627-1648.
  4. Heinlein, Reinhold & Krolzig, Hans-Martin, 2012. "On the construction of two-country cointegrated VAR models with an application to the UK and US," Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century 62310, Verein für Socialpolitik / German Economic Association.
  5. Anella Munro, 2014. "Exchange rates, expected returns and risk," Reserve Bank of New Zealand Discussion Paper Series DP2014/01, Reserve Bank of New Zealand.
  6. Reinhold Heinlein & Hans-Martin Krolzig, 2011. "Effects of monetary policy on the $/£ exchange rate. Is there a 'delayed overshooting puzzle'?," Studies in Economics 1124, Department of Economics, University of Kent.
  7. Bjørnland, Hilde C. & Jacobsen, Dag Henning, 2010. "The role of house prices in the monetary policy transmission mechanism in small open economies," Journal of Financial Stability, Elsevier, vol. 6(4), pages 218-229, December.
  8. Jääskelä, Jarkko P. & Jennings, David, 2011. "Monetary policy and the exchange rate: Evaluation of VAR models," Journal of International Money and Finance, Elsevier, vol. 30(7), pages 1358-1374.
  9. Menzies, Gordon D. & Zizzo, Daniel John, 2012. "Monetary policy and inferential expectations of exchange rates," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 22(2), pages 359-380.
  10. Reinhold Heinlein & Hans-Martin Krolzig, 2013. "Monetary Policy and Exchange Rates: A Balanced Two-Country Cointegrated VAR Model Approach," Studies in Economics 1321, Department of Economics, University of Kent.
  11. Charles Engel, 2013. "Exchange Rates and Interest Parity," NBER Working Papers 19336, National Bureau of Economic Research, Inc.

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