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Exchange Rate Overshooting: A Reassessment in a Monetary Framework

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  • Ghosh, Taniya
  • Bhadury, Soumya Suvra

Abstract

Most empirical studies on monetary policies have found exchange rate effects that are inconsistent with Dornbusch's overshooting hypothesis. Bjornland (2009) finds evidence of exchange rate overshooting by using interest rate alone as the monetary policy instrument. However, theoretically consistent way of identifying monetary policy requires capturing dual interaction between central bank's reaction to economic conditions and private sector's response to policy action. This calls for the introduction of "monetary‟ aggregates back in the models of exchange rate determination. Motivated by Bjornland's result, identification is achieved by imposing short-run and long-run restrictions while keeping the short-run interactions between monetary policy and exchange rate free. Using more appropriate econometric technique in a model aligned to theory, our paper rediscovers the validity of Dornbusch Overshooting hypothesis for Australia, Canada, New Zealand and Sweden more accurately and more robustly than Bjornland's original model.

Suggested Citation

  • Ghosh, Taniya & Bhadury, Soumya Suvra, 2017. "Exchange Rate Overshooting: A Reassessment in a Monetary Framework," MPRA Paper 90653, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:90653
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    References listed on IDEAS

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    1. Martin Eichenbaum & Charles L. Evans, 1995. "Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 110(4), pages 975-1009.
    2. Bjørnland, Hilde C., 2009. "Monetary policy and exchange rate overshooting: Dornbusch was right after all," Journal of International Economics, Elsevier, vol. 79(1), pages 64-77, September.
    3. Eric M. Leeper & Jennifer E. Roush, 2003. "Putting \"M\" back in monetary policy," International Finance Discussion Papers 761, Board of Governors of the Federal Reserve System (U.S.).
    4. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    5. Eric M. Leeper & Jennifer E. Roush, 2003. "Putting \\"M\\" back in monetary policy," Proceedings, Federal Reserve Bank of Cleveland, pages 1217-1264.
    6. William A. Barnett & Soumya Suvra Bhadury & Taniya Ghosh, 2016. "An SVAR Approach to Evaluation of Monetary Policy in India: Solution to the Exchange Rate Puzzles in an Open Economy," Open Economies Review, Springer, vol. 27(5), pages 871-893, November.
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    1. Heri Oscar Landa Díaz & Verónica Cerezo García, 2021. "La pandemia Covid-19, la crisis financiera y la dinámica (Overshooting) del tipo de cambio," Remef - Revista Mexicana de Economía y Finanzas Nueva Época REMEF (The Mexican Journal of Economics and Finance), Instituto Mexicano de Ejecutivos de Finanzas, IMEF, vol. 16(3), pages 1-22, Julio - S.

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    Keywords

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    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • F0 - International Economics - - General
    • F3 - International Economics - - International Finance
    • F30 - International Economics - - International Finance - - - General

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