Monetary policy and exchange rate overshooting: Dornbusch was right after all

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jinteco.2009.06.003 Byline: Hilde C. BjA[cedilla]rnland Keywords: Exchange rate; Uncovered interest parity (UIP); Dornbusch overshooting; Monetary policy; Structural vector autoregressive (VAR) Abstract: Dornbusch's exchange rate overshooting hypothesis is a central building block in international macroeconomics. Yet, empirical studies of monetary policy have typically found exchange rate effects that are inconsistent with overshooting. This puzzling result has been viewed by some researchers as a 'stylized fact' to be reckoned with in policy modelling. However, many of these studies, in particular those using vector autoregressive (VARs) approaches, have disregarded the strong contemporaneous interaction between monetary policy and exchange rate movements by placing zero restrictions on them. In contrast, we achieve identification by imposing a long-run neutrality restriction on the real exchange rate, thereby allowing for contemporaneous interaction between the interest rate and the exchange rate. In a study of four open economies, we find that the puzzles disappear. In particular, a contractionary monetary policy shock has a strong effect on the exchange rate, which appreciates on impact. The maximum effect occurs within 1-2 quarters, and the exchange rate thereafter gradually depreciates to baseline, consistent with the Dornbusch overshooting hypothesis and with few exceptions consistent with uncovered interest parity (UIP). Author Affiliation: Department of Economics, Norwegian School of Management (BI), Nydalsveien 37, 0484 Oslo, Norway Norges Bank, Bankplassen 2, P.O. Box 1179 Sentrum, N-0107 Oslo, Norway Article History: Received 11 January 2007; Revised 4 June 2009; Accepted 8 June 2009 Article Note: (footnote) [star] This paper has previously been circulated under the title: 'Monetary Policy and the Illusionary Exchange Rate Puzzle'. I am grateful for comments and suggestions from Steinar Holden, three anonymous referees, Leif Brubakk, Carlo A. Favero, Nils Gottfries, JA[cedilla]rn I. Halvorsen, Kai Leitemo, Jesper Linde, Sharon McCaw, Kjetil Olsen, AsbjA[cedilla]rn RA[cedilla]dseth, Luca Sala, and the participants at the seminars in the Bank of England, Norges Bank, Sveriges Riksbank, University of Oslo, Uppsala University and at the CEF 2006 conference in Cyprus and the EEA 2007 conference in Budapest. Thanks to Kathrine Lund for collecting the data. I gratefully acknowledge financial support from the Norwegian Financial Market Fund under the Norwegian Research Council. The usual disclaimer applies. The views expressed in this paper are those of the author and should not be attributed to Norges Bank.