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Monetary policy and the exchange rate: Evaluation of VAR models


  • Jääskelä, Jarkko P.
  • Jennings, David


This paper examines the ability of vector autoregressive (VAR) models to properly identify the transmission of monetary policy in a controlled experiment. Simulating data from a small open economy DSGE model estimated for Australia, we find that sign-restricted VAR models do reasonably well at estimating the responses of macroeconomic variables to monetary policy shocks. This is in contrast to models that use recursive zero-type restrictions, for which inflation can rise following an unexpected interest rate increase while the exchange rate can appreciate or depreciate depending on the ordering of the variables. Sign-restricted VAR models seem to be able to overcome puzzles related to the real exchange rate, provided that a sufficient number of different types of shocks are identified. Despite delivering the correct sign of the impulse responses, central tendency measures of sign-restricted VAR models can, however, be misleading and hardly ever coincide with the true impulses. This finding casts doubt on the common notion that the median impulses are the ‘most probable’ description of the true data-generating process.

Suggested Citation

  • Jääskelä, Jarkko P. & Jennings, David, 2011. "Monetary policy and the exchange rate: Evaluation of VAR models," Journal of International Money and Finance, Elsevier, vol. 30(7), pages 1358-1374.
  • Handle: RePEc:eee:jimfin:v:30:y:2011:i:7:p:1358-1374 DOI: 10.1016/j.jimonfin.2011.06.014

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    References listed on IDEAS

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    Cited by:

    1. Forhad, Abdur Rahman & Homaifar, Ghassem A. & Salimullah, Abul Hasnat Muhammed, 2017. "Monetary Policy Transmission Effect On The Real Sector Of The Bangladesh Economy: An Svar Approach," Economia Internazionale / International Economics, Camera di Commercio Industria Artigianato Agricoltura di Genova, vol. 70(1), pages 25-46.
    2. K. Istrefi & B. Vonnak, 2015. "Delayed Overshooting Puzzle in Structural Vector Autoregression Models," Working papers 576, Banque de France.
    3. Fisher, Lance A. & Huh, Hyeon-seung, 2016. "Monetary policy and exchange rates: Further evidence using a new method for implementing sign restrictions," Journal of Macroeconomics, Elsevier, vol. 49(C), pages 177-191.

    More about this item


    VAR models; Sign restrictions; Shock identification; Small open economy models;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models


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