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Revisiting the Exchange Rate Response to Monetary Policy Innovations: The Role of Spillovers of U.S. News Shocks

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  • Pierre De Leo

    (Boston College)

  • Vito Cormun

    (Boston College)

Abstract

Recursive vector autoregression (VAR) analysis suggests that the nominal exchange rate tends to depreciate after a contractionary monetary policy shock in most developing countries, a puzzle for virtually all open-economy macroeconomic models. Using a structural VAR approach, we document that when the U.S. economic outlook worsens developing countries' exchange rates signicantly depreciate and their policy-controlled interest rates increase. We show that commonly used recursive VAR schemes inevitably confound these correlations for the monetary policy innovation. In our econometric framework, we identify the spillover effects of future U.S. business cycles as the innovations that best explain future movements in the Federal Funds rate over an horizon of two years. When the monetary policy shock is then cleansed of these variations, the exchange rate response puzzle disappears. We conclude by showing that a standard small open economy model with news about future fundamentals in a large economy is consistent with all the empirical findings of this paper.

Suggested Citation

  • Pierre De Leo & Vito Cormun, 2017. "Revisiting the Exchange Rate Response to Monetary Policy Innovations: The Role of Spillovers of U.S. News Shocks," 2017 Meeting Papers 576, Society for Economic Dynamics.
  • Handle: RePEc:red:sed017:576
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    References listed on IDEAS

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    1. Avdjiev, Stefan & Hardy, Bryan & Kalemli-Ozcan, Sebnem & Serv�n, Luis, 2017. "Gross Capital Inflows to Banks, Corporates and Sovereigns," CEPR Discussion Papers 11806, C.E.P.R. Discussion Papers.
    2. Uribe, Martin & Yue, Vivian Z., 2006. "Country spreads and emerging countries: Who drives whom?," Journal of International Economics, Elsevier, vol. 69(1), pages 6-36, June.
    3. Kohlscheen, Emanuel, 2014. "The impact of monetary policy on the exchange rate: A high frequency exchange rate puzzle in emerging economies," Journal of International Money and Finance, Elsevier, vol. 44(C), pages 69-96.
    4. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2005. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 1-45, February.
    5. Vicondoa, Alejandro, 2016. "Monetary News, U.S. Interest Rate and Business Cycles in Emerging Economies," Economics Working Papers ECO2016/10, European University Institute.
    6. Kim, Soyoung & Roubini, Nouriel, 2000. "Exchange rate anomalies in the industrial countries: A solution with a structural VAR approach," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 561-586, June.
    7. Rey, Hélène, 2015. "Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence," CEPR Discussion Papers 10591, C.E.P.R. Discussion Papers.
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    Cited by:

    1. Paul Rudel & Peter Tillmann, 2018. "News Shock Spillovers: How the Euro Area Responds to Expected Fed Policy," MAGKS Papers on Economics 201832, Philipps-Universität Marburg, Faculty of Business Administration and Economics, Department of Economics (Volkswirtschaftliche Abteilung).

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