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

• Published in: Journal of international economics 2009-09, Vol.79 (1), p.64-77
• Main Author: Bjornland, Hilde C
• Format: Article
• Language: English
• Subjects: Dornbusch overshooting; Economic impact; Exchange rate; Exchange rate policy; Exchange rate Uncovered interest parity (UIP) Dornbusch overshooting Monetary policy Structural vector autoregressive (VAR); Exchange rates; Foreign exchange rates; Hypotheses; Interest rates; Monetary policy; Purchasing power parity; Regression analysis; Structural vector autoregressive (VAR); Studies; Uncovered interest parity (UIP); Vector-autoregressive models
• ISSN: 0022-1996; 1873-0353
• DOI: 10.1016/j.jinteco.2009.06.003

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).