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The Impact of Monetary Policy on the Exchange Rate: puzzling evidence from three emerging economies

  • Emanuel Kohlscheen

This study investigates the impact effect of monetary policy shocks on the exchange rates of Brazil, Mexico and Chile. We find that even a focus on 1 day exchange rate changes following policy events – which reduces the potential for reverse causality considerably – fails to lend support for the conventional view that associates interest rate hikes with appreciations. This lack of empirical backing for the predictions of standard open economy models that, for instance, combine the UIP condition with rational expectations (as in Dornbusch (1976)) persists irrespective of whether we use the US Dollar or effective exchange rates, whether interest rate changes are anticipated or not, whether changes in the policy rate that were followed by exchange rate intervention are excluded or whether "contaminated" events are dropped from the analysis. We argue that it is difficult to attribute this stronger version of the exchange rate puzzle to fiscal dominance, as similar results are obtained in the case of Chile - a country that has had the highest possible short-term credit rating since 1997 and a debt/GDP ratio below 10%. Indeed, in Chile a 100 b.p. hike leads to a 2.2 to 2.6% devaluation of the Peso on impact.

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File URL: http://www.bcb.gov.br/pec/wps/ingl/wps259.pdf
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Paper provided by Central Bank of Brazil, Research Department in its series Working Papers Series with number 259.

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Date of creation: Nov 2011
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Handle: RePEc:bcb:wpaper:259
Contact details of provider: Web page: http://www.bcb.gov.br/?english

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  1. Jonathan Kearns & Phil Manners, 2005. "The Impact of Monetary Policy on the Exchange Rate: A Study Using Intraday Data," RBA Research Discussion Papers rdp2005-02, Reserve Bank of Australia.
  2. Kraay, Aart, 2000. "Do high interest rates defend currencies during speculative attacks ?," Policy Research Working Paper Series 2267, The World Bank.
  3. Philippe Aghion & Philippe Bacchetta & Abhijit Banerjee, 1999. "A Simple Model of Monetary Pollicy and Currency Crises," Working Papers 99.05, Swiss National Bank, Study Center Gerzensee.
  4. Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2001. "Currency crises and monetary policy in an economy with credit constraints," European Economic Review, Elsevier, vol. 45(7), pages 1121-1150.
  5. Carmen M. Reinhart & Kenneth S. Rogoff, 2002. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," NBER Working Papers 8963, National Bureau of Economic Research, Inc.
  6. Maurice J. Roche & Michael J. Moore, 2007. "Solving Exchange Rate Puzzles with neither Sticky Prices nor Trade Costs," Economics, Finance and Accounting Department Working Paper Series n1750507, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
  7. Jon Faust & John H. Rogers & Shing-Yi B. Wang & Jonathan H. Wright, 2003. "The high-frequency response of exchange rates and interest rates to macroeconomic announcements," International Finance Discussion Papers 784, Board of Governors of the Federal Reserve System (U.S.).
  8. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," 2006 Meeting Papers 872, Society for Economic Dynamics.
  9. Philippe Bacchetta & Eric van Wincoop, 2010. "Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle," American Economic Review, American Economic Association, vol. 100(3), pages 870-904, June.
  10. Goncalves, Carlos Eduardo S. & Salles, Joao M., 2008. "Inflation targeting in emerging economies: What do the data say?," Journal of Development Economics, Elsevier, vol. 85(1-2), pages 312-318, February.
  11. Jun Pan & Kenneth J. Singleton, 2008. "Default and Recovery Implicit in the Term Structure of Sovereign "CDS" Spreads," Journal of Finance, American Finance Association, vol. 63(5), pages 2345-2384, October.
  12. Emanuel Kohlscheen, 2010. "Emerging Floaters: pass-throughs and (some) new commodity currencies," Working Papers Series 224, Central Bank of Brazil, Research Department.
  13. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2008. "Carry Trades and Currency Crashes," NBER Working Papers 14473, National Bureau of Economic Research, Inc.
  14. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
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