The Exchange Rate Response Puzzle
49 Pages Posted: 1 Feb 2012 Last revised: 7 Aug 2012
Date Written: May 31, 2012
We present a new data fact: in response to a monetary tightening, the nominal exchange tends to appreciate in developed countries but depreciate in developing countries. A model is formalized to rationalize this puzzling pattern. It has three key channels of monetary transmission: a liquidity demand channel, a fiscal channel and an output channel. These have offsetting effects on the exchange rate. The paper shows that a calibrated version of the model can explain the contrast between developed and developing countries. Using counterfactual experiments we identify differences in the liquidity demand effect as being key to the contrasting responses generated by the model. Finally, the paper provides independent evidence of systematic variation between appreciating and depreciating countries in the strength of the liquidity demand effect.
Keywords: Monetary policy, interest rates, exchange rates
JEL Classification: F3, F4
Suggested Citation: Suggested Citation