New Evidence on the Puzzles: Monetary Policy and Exchange Rates
AbstractPast empirical research on monetary policy in open economies has found the â€œdelayed overshootingâ€, the â€œforward discountâ€ and the â€œexchange rateâ€ puzzles. We revisit the effects of monetary policy on exchange rates by applying Uhlig's (2005) identification procedure that involves sign restrictions on the impulse responses of selected variables. We impose no restrictions on the exchange rate to leave the key question as open as possible. Importantly, our identification scheme avoids the â€œprice puzzleâ€. We find that the puzzles regarding the exchange rate are still there, but that the quantitative features are different. In response to US monetary policy shocks, the peak appreciation happens during the first year after the shock for the US-UK and the US-Japan country pair and during the first two years for the US-Germany country pair. There is a robust forward discount puzzle implying a large risk premium. We study this issue by calculating conditional Sharpe ratios for a Bayesian investor investing in a hedged position following a US monetary policy shock. For foreign monetary policy shocks, we find a considerable uncertainty regarding the initial reaction of the exchange rate. Quantitatively, monetary policy shocks seem to have a minor impact on exchange rate fluctuations
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Bibliographic InfoPaper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 5.
Date of creation: 04 Jul 2006
Date of revision:
vector autoregressions; agnostic identification; forward discount bias puzzle; exchange rate puzzle; monetary policy;
Find related papers by JEL classification:
- C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
- F31 - International Economics - - International Finance - - - Foreign Exchange
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-07-15 (All new papers)
- NEP-CBA-2006-07-15 (Central Banking)
- NEP-FMK-2006-07-15 (Financial Markets)
- NEP-IFN-2006-07-15 (International Finance)
- NEP-MAC-2006-07-15 (Macroeconomics)
- NEP-MON-2006-07-15 (Monetary Economics)
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