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Monetary policy shocks and exchange rate dynamics in small open economies

Author

Listed:
  • Madison Terrell

    (Reserve Bank of Australia)

  • Qazi Haque

    (University of Adelaide)

  • Jamie L. Cross

    (University of Melbourne)

  • Firmin Doko Tchatoka

    (University of Adelaide)

Abstract

This paper investigates the relationship between monetary policy shocks and real exchange rates in several small open economies. To that end, we develop a novel identification strategy for time-varying structural vector autoregressions with stochastic volatility. Our approach combines short-run and long-run restrictions to preserve the contemporaneous interaction between the interest rate and the exchange rate. Using this framework, we find that the volatility of monetary policy shocks has substantially decreased in all countries. This leads to a considerable reduction in the significance of policy shocks in explaining exchange rate and macroeconomic fluctuations since the 1990s. However, we find that the dynamic effects of the policy shocks have remained stable over time. Finally, while we do identify violations of uncovered interest parity (UIP) in some countries, we find no evidence of the ‘exchange rate puzzle’ or the ‘delayed overshooting puzzle’ in any country.

Suggested Citation

  • Madison Terrell & Qazi Haque & Jamie L. Cross & Firmin Doko Tchatoka, 2023. "Monetary policy shocks and exchange rate dynamics in small open economies," School of Economics and Public Policy Working Papers 2023-04 Classification-C3, University of Adelaide, School of Economics and Public Policy.
    • Handle: RePEc:adl:wpaper:2023-04
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    Cited by:

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    More about this item

    Keywords

    Monetary policy shocks; Exchange rate; Dornbusch overshooting; UIP; TVP-VARs.;
    All these keywords.

    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; State Space Models
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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