Reassessing exchange rate overshooting in a monetary framework

Soumya Suvra Bhadury and Taniya Ghosh
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Soumya Suvra Bhadury: University of Kansas

Indira Gandhi Institute of Development Research, Mumbai Working Papers from Indira Gandhi Institute of Development Research, Mumbai, India

Abstract: Money overtime has been deemphasized from most of the macroeconometric models of exchange rate making interest rate 'alone' the monetary policy instrument. One such model is Bjornland's (1999) Journal of International Economics and Monetary Policy and Exchange Rate Overshooting: Dornbusch was right after all. The model sets out to establish the empirical validity of Dornbusch exchange rate overshooting hypothesis for four small open economies. It does so though not with exact precision. When the same model is done using the correct econometric techniques, the impulse response functions for exchange rate due to a monetary policy shock are infact 'insignificant'. In this paper we revisit the Dornbusch exchange rate overshooting in a different model setting. A real money demand equations is added to the original model. Identification is achieved by imposing short-run and long-run restrictions while keeping the short-run interactions between the two variables monetary policy and exchange rate free. Classical neutrality of money is imposed according to which the monetary shocks are long-run neutral to certain real variables. Our paper rediscovers the validity of Dornbusch Overshooting hypothesis for Australia, Canada, Newzealand and Sweden when we compare it with Bjornland's model. More specifically, a contractionary monetary policy shock leads to exchange rate overshooting as predicted by Dornbusch. The exchange rate appreciates 'significantly' on impact to a monetary policy shock as shown by the impulse response functions and thereafter depreciates. Also the variance decomposition results justify our analysis by showing that money demand and money supply shocks explain siginificant portion of exchange rate fluctuations vis-a-vis Bjornland's original model.

Keywords: Monetary Policy; Money Demand; Structural VAR; Short Run; Long Run; Exchange Rate Overshooting; Liquidity Puzzle; Price Puzzle; Exchange Rate Puzzle; Forward Discount Bias Puzzle (search for similar items in EconPapers)
JEL-codes: C32 E41 E51 E52 F31 F41 F47 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2015-06
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-opm
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