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Monetary policy's role in exchange rate behavior

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  • Jon Faust
  • John H. Rogers

Abstract

While much empirical work has addressed the role of monetary policy shocks in exchange rate behavior, conclusions have been clouded by the lack of plausible identifying assumptions. We apply a recently developed inference procedure allowing us to relax dubious identifying assumptions. This work overturns some earlier results and strengthens others: i) Contrary to earlier findings of "delayed overshooting," the peak exchange rate effect of policy shocks may come nearly immediately after the shock; ii) In every otherwise reasonable identification, monetary policy shocks lead to large uncovered interest rate parity (UIP) deviations; iii) Monetary policy shocks may account for a smaller portion of the variance of exchange rates than found in earlier estimates. While (i) is consistent with overshooting, (ii) implies that the overshooting cannot be driven by Dornbusch's mechanism, and (iii) gives reason to doubt whether monetary policy shocks are the main source of exchange rate volatility.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 652.

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Date of creation: 1999
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Handle: RePEc:fip:fedgif:652

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Keywords: Monetary policy ; Foreign exchange rates;

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  3. Clarida, R. & Gali, J., 1993. "Sources of Real Exchange Rate Fluctuations: How Important are Nominal Shocks?," Discussion Papers 1993_25, Columbia University, Department of Economics.
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