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The Effect of Monetary Policy on Exchange Rates: How to Solve the Puzzles

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  • Kumah, F.Y.

    (Tilburg University, Center for Economic Research)

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    Abstract

    Recent empirical research on the effects of monetary policy shocks on exchange rate fluctuations have encountered the exchange rate puzzle and th e forward discount bias puzzle.The exchange rate puzzle is the tendency of the domestic currency (of non-US G-7 countries) to depreciate against the US dollar following domestic monetary tightening.Forward discount bias puzzle is the failure of empirical research to find results consistent with the requirement that if uncovered interest parity holds then domestic monetary tightening (given that foreign monetary policy remains put) should be associated with an initial impact appreciation of the domestic currency followed by a gradual depreciation. This paper takes the current debate in the monetary policy literature on the measurement of monetary policy shocks a step further into international finance. The main objective here is to assess the relative performance of monetary policy identification schemes in helping solve (or generate) the puzzles mentioned above.The identification schemes considered include a fully recursive identification scheme, a semi-recursive identification scheme and a structural VAR model that explicitly incorporates international monetary policy interdependence into the identification of monetary policy shocks.The structural VAR identification scheme yields very plausible contemporaneous and dynamic estimates of the effects of monetary policy shocks on bilateral exchange rates for the data-set of the respective countries considered; and the puzzles largely disappear.

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    Bibliographic Info

    Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 1996-70.

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    Date of creation: 1996
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    Handle: RePEc:dgr:kubcen:199670

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    Related research

    Keywords: monetary policy; exchange rate;

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    Cited by:
    1. W. Jos Jansen, 2008. "Inside The Impossible Triangle: Monetary Policy Autonomy In A Credible Target Zone," Contemporary Economic Policy, Western Economic Association International, vol. 26(2), pages 216-228, 04.
    2. W. Jos Jansen, 2000. "On the Cost of Moving from a Quasi Monetary Union to a Full Monetary Union: The Case of the Netherlands," MEB Series (discontinued) 2000-1, Netherlands Central Bank, Monetary and Economic Policy Department.

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