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Effects of monetary policy on the $/£ exchange rate. Is there a 'delayed overshooting puzzle'?

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  • Reinhold Heinlein

    ()

  • Hans-Martin Krolzig

    ()

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    Abstract

    The determination of the $/£ exchange rate is studied in a small symmetric macroeconometric model including UK-US differentials in inflation, output gap, short and long-term interest rates for the four decades since the breakdown of Bretton Woods. The key question addressed is the possible presence of a ‘delayed overshooting puzzle’ in the dynamic reaction of the exchange rate to monetary policy shocks. In contrast to the existing literature, we follow a data-driven modelling approach combining (i) a VAR based cointegration analysis with (ii) a graph-theoretic search for instantaneous causal relations and (iii) an automatic general-to-specific approach for the selection of a congruent parsimonious structural vector equilibrium correction model. We find that the long-run properties of the system are characterized by four cointegration relations and one stochastic trend, which is identified as the long-term interest rate differential and that appears to be driven by long-term inflation expectations as in the Fisher hypothesis. It cointegrates with the inflation differential to a stationary ‘real’ long-term rate differential and also drives the exchange rate. The short-run dynamics are characterized by a direct link from the short-term to the long-term interest rate differential. Jumps in the exchange rate after short-term interest rate variations are only significant at 10%. Overall, we find strong evidence for delayed overshooting and violations of UIP in response to monetary policy shocks.

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    Bibliographic Info

    Paper provided by Department of Economics, University of Kent in its series Studies in Economics with number 1124.

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    Date of creation: Dec 2011
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    Handle: RePEc:ukc:ukcedp:1124

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    Postal: Department of Economics, University of Kent at Canterbury, Canterbury, Kent, CT2 7NP
    Phone: +44 (0)1227 764000
    Fax: +44 (0)1227 827850
    Web page: http://www.ukc.ac.uk/economics/

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    Related research

    Keywords: Exchange Rates; Monetary Policy; Cointegration; Structural VAR; Model Selection;

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