Revisiting the Exchange Rate Response to Monetary Policy Innovations: The Role of Spillovers of U.S. News Shocks

Pierre De Leo and Vito Cormun

No 576, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: Recursive vector autoregression (VAR) analysis suggests that the nominal exchange rate tends to depreciate after a contractionary monetary policy shock in most developing countries, a puzzle for virtually all open-economy macroeconomic models. Using a structural VAR approach, we document that when the U.S. economic outlook worsens developing countries' exchange rates signicantly depreciate and their policy-controlled interest rates increase. We show that commonly used recursive VAR schemes inevitably confound these correlations for the monetary policy innovation. In our econometric framework, we identify the spillover effects of future U.S. business cycles as the innovations that best explain future movements in the Federal Funds rate over an horizon of two years. When the monetary policy shock is then cleansed of these variations, the exchange rate response puzzle disappears. We conclude by showing that a standard small open economy model with news about future fundamentals in a large economy is consistent with all the empirical findings of this paper.

Date: 2017
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-opm
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