Exchange Rate Undershooting: Evidence and Theory

53 Pages Posted: 27 Mar 2019

See all articles by Gernot J. Müller

Gernot J. Müller

University of Tuebingen - Department of Economics

Martin Wolf

University of Vienna - Department of Economics; Centre for Economic Policy Research (CEPR)

Thomas Hettig

University of Tuebingen

Date Written: March 2019

Abstract

We run local projections to estimate the effect of US monetary policy shocks on the dollar. We find that monetary contractions appreciate the dollar and establish two results. First, the spot exchange rate undershoots: the appreciation is smaller on impact than in the longer run. Second, forward exchange rates also appreciate on impact, but their response is flat across tenors. Next, we develop and estimate a New Keynesian model with information frictions. In the model, investors do not observe the natural rate of interest directly. As a result, they learn only over time whether an interest rate surprise represents a monetary contraction. The model accurately predicts the joint dynamics of spot and forward exchange rates following a monetary contraction.

Keywords: Forward Exchange Rate, Forward premium puzzle, information effect, Information Frictions, monetary policy, Spot Exchange Rate, UIP puzzle

JEL Classification: E43, F31

Suggested Citation

Müller, Gernot J. and Wolf, Martin and Hettig, Thomas, Exchange Rate Undershooting: Evidence and Theory (March 2019). CEPR Discussion Paper No. DP13597, Available at SSRN: https://ssrn.com/abstract=3360064

Gernot J. Müller

University of Tuebingen - Department of Economics ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074
Germany

Martin Wolf

University of Vienna - Department of Economics ( email )

Oskar-Morgenstern-Platz 1
Vienna, Vienna 1180
Austria

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Thomas Hettig (Contact Author)

University of Tuebingen ( email )

Wilhelmstr. 19
72074 Tuebingen, Baden Wuerttemberg 72074
Germany

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