The effects of permanent monetary shocks on exchange rates and uncovered interest rate differentials

This paper shows that in a new Keynesian model of the open economy with portfolio adjustment costs a permanent increase in the nominal interest rate causes in the short run a depreciation of the nominal and real exchange rates and a deviation from uncovered interest rate parity against the tightening country. These effects have the opposite sign than those associated with transitory increases in the nominal interest rate. The paper then estimates an empirical model of exchange rates and uncovered interest rate differentials with permanent and transitory U.S. monetary policy shocks on post-Bretton-Woods data from the United States, the United Kingdom, Japan, and Canada. The estimated impulse responses to permanent monetary shocks are shown to be qualitatively consistent with the predictions of the theoretical model.