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

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Author Info
Hilde C. Bjørnland () (Norwegian School of Management (BI), Norges Bank (Central Bank of Norway) and UC Berkeley)

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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 VARs, 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 UIP.

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Publisher Info
Paper provided by Norges Bank in its series Working Paper with number 2009/09.

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Length: 30 pages
Date of creation: 05 Jun 2009
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Handle: RePEc:bno:worpap:2009_09

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Related research
Keywords: Exchange rate; uncovered interest parity (UIP); Dornbusch overshooting; monetary policy; Structural VAR.;

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Find related papers by JEL classification:
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
F31 - International Economics - - International Finance - - - Foreign Exchange
F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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This page was last updated on 2009-12-4.

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