Exchange Rate Anomalies in the Industrial Countries: A Solution with a Structural VAR Approach

Abstract

Past empirical research on the effects of monetary policy in closed and open economies found evidence of several anomalies, such as the 'liquidity', 'price', 'exchange rate' and 'forward discount bias' puzzles. In this paper, we develop an approach that provides a solution to these empirical anomalies in an open economy setup. We use a 'structural VAR' approach with non-recursive contemporaneous restrictions and we identify monetary policy shocks by modeling the reaction function of the monetary authorities and the structure of the economy. Our empirical findings are that effects of non-US G-7 monetary policy shocks on exchange rates and other macroeconomic variables are consistent with the predictions of a broad set of theoretical models. The evidence is consistent with significant, but transitory, real effects of monetary shocks. The 'price' puzzle is addressed and there is little evidence of open economy anomalies. Specifically, initially the exchange rate appreciates in response to a monetary contraction; but after a few months, the exchange rate depreciates over time in accordance with the uncovered interest parity condition. Overall, our identification scheme gives results that contribute to resolve the empirical anomalies about the effects of monetary policy shocks found in the literature.

Keywords: monetary policy shocks, exchange rates, G-7 countries, structural VAR

JEL Classification: C32, E52, F31, F42