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

Hilde Bjørnland ()

No 2009/09, Working Paper from Norges Bank

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 VARs, 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 UIP.

Keywords: Exchange rate; uncovered interest parity (UIP); Dornbusch overshooting; monetary policy; Structural VAR. (search for similar items in EconPapers)
JEL-codes: E32 E52 F31 F41 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2009-06-05
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mac, nep-mon and nep-opm
References: Add references at CitEc
Citations: View citations in EconPapers (93)

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Journal Article: Monetary policy and exchange rate overshooting: Dornbusch was right after all (2009)
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Persistent link: https://EconPapers.repec.org/RePEc:bno:worpap:2009_09

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