The Effect of Monetary Policy on Exchange Rates: How to Solve the Puzzles

Abstract

Recent empirical research on the effects of monetary policy shocks on exchange rate fluctuations have encountered the exchange rate puzzle and the forward discount bias puzzle. The exchange rate puzzle is the tendency of the domestic currency (of non-U.S. G-7 countries) to depreciate against the U.S. dollar following domestic monetary tightening. Forward discount bias puzzle is the failure of empirical research to find results consistent with the requirement that if uncovered interest parity holds then domestic monetary tightening (given that foreign monetary policy remains put) should be associated with an initial impact appreciation of the domestic currency followed by a gradual depreciation. This paper takes the current debate in the monetary policy literature on the measurement of monetary policy shocks a step further into international finance. The main objective here is to assess the relative performance of monetary policy identification schemes in helping solve (or generate) the puzzles mentioned above. The identification schemes considered include a fully recursive identification scheme, a semi-recursive identification scheme and a structural VAR model that explicitly incorporates international monetary policy interdependence into the identification of monetary policy shocks. The structural VAR identification scheme yields very plausible contemporaneous and dynamic estimates of the effects of monetary policy shocks on bilateral exchange rates for the data-set of the respective countries considered, and the puzzles largely disappear.

JEL Classification: F31, F41, F52