Monetary policy shocks and exchange rate dynamics in small open economies

In this paper we provide new insights on the dynamics between monetary policy shocks and real exchange rates in small open economies using a time-varying structural vector autoregression model with stochastic volatility. Identification is achieved using a combination of short-run and long-run restrictions while preserving the contemporaneous interaction between monetary policy and the exchange rate. For several small open economies, we find no evidence of the ‘exchange rate puzzle’ or the ‘delayed overshooting puzzle,’ in line with recent studies on this topic (see e.g. Bj rnland, 2009). However, there is evidence of the ‘forward discount puzzle’ in some countries, suggesting that the uncovered interest parity (UIP) is violated. In addition, a substantial decrease in the volatility of monetary policy shocks is evident in most countries, accompanied by a decline in the importance of policy shocks in explaining the volatility of exchange rates and other macroeconomic variables since the 1990s.