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Monetary Policy and Exchange Rates: A Balanced Two-Country Cointegrated VAR Model Approach

Author

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  • Reinhold Heinlein

    ()

  • Hans-Martin Krolzig

    ()

Abstract

We study the exchange rate effects of monetary policy in a balanced macroeconometric two-country model for the US and UK. In contrast to the empirical literature on the 'delayed overshooting puzzle', which consistently treats the domestic and foreign countries unequally in themodelling process, we consider the full model feedback, allowing for a thorough analysis of the system dynamics. The consequential inevitable problem of model dimensionality is tackled in this paper by invoking the approach by Aoki (1981) commonly used in economic theory. Assuming country symmetry in the long-run allows to decouple the two-country macro dynamics of country averages and country differences such that the cointegration analysis can be applied to much smaller systems. Secondly the econometric modelling is general-to-specific, a graph-theoretic approach for the contemporaneous effects combined with an automatic general-to-specific model selection. The resulting parsimonious structural vector equilibrium correction model ensures highly significant impulse responses, revealing a delayed overshooting of the exchange rate in the case of a Bank of England monetary shock but suggests an instantaneous response to a Fed shock. Altogether the response is more pronounced in the former case.

Suggested Citation

  • Reinhold Heinlein & Hans-Martin Krolzig, 2013. "Monetary Policy and Exchange Rates: A Balanced Two-Country Cointegrated VAR Model Approach," Studies in Economics 1321, School of Economics, University of Kent.
  • Handle: RePEc:ukc:ukcedp:1321
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    References listed on IDEAS

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    1. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    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. Garratt, Anthony & Lee, Kevin & Pesaran, M. Hashem & Shin, Yongcheol, 2012. "Global and National Macroeconometric Modelling: A Long-Run Structural Approach," OUP Catalogue, Oxford University Press, number 9780199650460.
    4. Scholl, Almuth & Uhlig, Harald, 2008. "New evidence on the puzzles: Results from agnostic identification on monetary policy and exchange rates," Journal of International Economics, Elsevier, vol. 76(1), pages 1-13, September.
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    Cited by:

    1. Georgiadis, Georgios & Jancokova, Martina, 2017. "Financial Globalisation, Monetary Policy Spillovers and Macro-modelling: Tales from 1001 Shocks," Globalization and Monetary Policy Institute Working Paper 314, Federal Reserve Bank of Dallas.

    More about this item

    Keywords

    Two-country model; Cointegration; Structural VAR; Gets Model Selection; Monetary Policy; Exchange Rates;

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C50 - Mathematical and Quantitative Methods - - Econometric Modeling - - - General

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