Has Money Lost Its Relevance? Resolving the Exchange Rate Disconnect Puzzle

Taniya Ghosh and Soumya Suvra Bhadury

MPRA Paper from University Library of Munich, Germany

Abstract: The objective of this study is to identify the monetary policy shock causing exchange rate fluctuations in the economies of India, Poland and the UK. For this purpose, an open-economy structural vector auto-regression model is used, resorting to data covering the period 2000-2015. The model used in the paper is appropriate for the small, open economies being analysed here as it facilitates estimation of theoretically correct and significant responses in terms of the price, output, and exchange rate to monetary policy tightening. The importance of monetary policy shock is established by examining the variance decomposition of forecast error, impulse response function, and out-of-sample forecast. The model also allows for the precise measurement of money through the adoption of a new monetary measure, namely, aggregation–theoretic Divisia monetary aggregate. The empirical results lead to three critical findings. Firstly, it is imperative to consider the estimated responses of output, prices, money and exchange rate to monetary policy shocks in models using monetary aggregates. Secondly, the incorporation of Divisia money in monetary policy helps in explaining fluctuations in the exchange rate. Thirdly, the inclusion of Divisia money also promotes better out-of-sample forecasting of the exchange rate.

Keywords: Monetary policy; Monetary aggregates; Divisia; Structural VAR; Exchange rate overshooting; Liquidity puzzle; Price puzzle; Exchange rate disconnect puzzle; Forward discount bias puzzle (search for similar items in EconPapers)
JEL-codes: E5 F00 (search for similar items in EconPapers)
Date: 2018-10-02
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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