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Permanent and temporary monetary policy shocks and the dynamics of exchange rates

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  • Carvalho, Alexandre
  • Valle e Azevedo, João
  • Pires Ribeiro, Pedro

Abstract

We show the distinction between permanent and temporary monetary policy shocks is helpful to understand the impacts of monetary policy on exchange rates in the short as well as over the long run. Drawing on monthly data for several advanced economies from 1971 to 2019 and resorting to a simple structural vector error correction (SVEC) model, we find that a shock leading to a temporary increase in U.S. nominal interest rates leads to a temporary appreciation of the USD against the other currencies. In turn, a monetary policy shock leading to a permanent rise in nominal interest rates – e.g., one associated with a normalisation of monetary policy after a long period at the zero lower bound – results in a depreciation of the USD, in the short as well as over the long run that may contribute to higher (not lower) inflation also in the short run.

Suggested Citation

  • Carvalho, Alexandre & Valle e Azevedo, João & Pires Ribeiro, Pedro, 2024. "Permanent and temporary monetary policy shocks and the dynamics of exchange rates," Journal of International Economics, Elsevier, vol. 147(C).
    • Handle: RePEc:eee:inecon:v:147:y:2024:i:c:s0022199623001575
    DOI: 10.1016/j.jinteco.2023.103871
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    More about this item

    Keywords

    Exchange rates; Fisher relation; Monetary policy cointegration; Monetary shocks; Structural VEC models;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • 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

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