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Monetary policy and the illusionary exchange rate puzzle

  • Hilde C. Bjørnland

    ()

    (Department of Economics, University of Oslo and Norges Bank (Central Bank of Norway))

Dornbusch’s exchange rate overshooting hypothesis is a central building block in international macroeconomics. Yet, empirical studies of monetary policy have typically found exchange rate effects that are inconsistent with overshooting. This puzzling result has developed into a “styled facts” to be reckoned with in policy modelling. However, many of these studies, in particular those using VARs, have disregarded the strong contemporaneous interaction between monetary policy and exchange rate movements by placing zero restriction on them. By instead imposing a long-run neutrality restriction on the real exchange, thereby allowing the interest rate and the exchange rate to react simultaneously to any news, I find that the puzzles disappear. In particular, a contractionary monetary policy shock has a strong effect on the exchange rate that appreciates on impact. The maximum effect occurs immediately, and the exchange rate thereafter gradually depreciates to baseline, consistent with the Dornbusch overshooting hypothesis and with few exceptions consistent with UIP.

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Paper provided by Norges Bank in its series Working Paper with number 2005/11.

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Length: 30 pages
Date of creation: 09 Nov 2005
Date of revision:
Handle: RePEc:bno:worpap:2005_11
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