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Journal ArticleDOI

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

01 Jan 1996-Social Science Research Network (Macroeconomics)-
TL;DR: The authors assess the relative performance of monetary policy identification schemes in helping solve (or generate) the exchange rate puzzle and forward discount bias puzzle in international finance and propose a structural VAR model that explicitly incorporates international monetary policy interdependence into the identification of monetarypolicy shocks.
Abstract: Recent empirical research on the effects of monetary policy shocks on exchange rate fluctuations have encountered the exchange rate puzzle and th e forward discount bias puzzle.The exchange rate puzzle is the tendency of the domestic currency (of non-US G-7 countries) to depreciate against the US 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.

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Citations
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Journal ArticleDOI
TL;DR: The authors examined the impact of monetary policy using Israeli data on nominal and indexed bonds, which allow them to decompose nominal interest rates into inflation expectations and ex ante real interest rates, and found that a monetary policy shock, introduced by raising the overnight rate the Bank of Israel charges member banks, raises real interest rate but lowers inflation expectations.

36 citations


Cites background or methods from "The Effect of Monetary Policy on Ex..."

  • ...However, several recent papers suggest other identifying restrictions (e.g., Bernanke and Mihov, 1995; Kim and Roubini, 1995; Kumah, 1997)....

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  • ...In other words, we measure monetary policy shocks of time-t by changes in the BOI interest rate that are orthogonal to: * Changes in all variables (i.e., of types I, II, and III) observed prior to time t (up to time t 1), and * Contemporaneous (i.e., time t) changes in the non-policy variables on which the BOI bases its monetary policy (i.e., type I variables such as contemporaneous changes in inflation expectations)....

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  • ...In other words, we measure monetary policy shocks of time-t by changes in the BOI interest rate that are orthogonal to: * Changes in all variables (i.e., of types I, II, and III) observed prior to time t (up to time t 1), and * Contemporaneous (i.e., time t) changes in the non-policy variables on…...

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  • ...Changes in this rate are based, in recent years, on several indicators that, considered together, illuminate the monetary picture and indicate how necessary it is to tighten or loosen monetary policy to achieve inflation targets.3 Among those indicators, the inflation environment is assessed by the recent rate of inflation and by inflation expectations to 12 months, which are derived from the government indexed-bond market....

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Journal ArticleDOI
TL;DR: The authors empirically examined whether the interaction between foreign exchange markets and monetary markets can help to resolve the forward discount puzzle and showed that the liquidity measure identified above has an impact on forward premiums, and that once the liquidity effect is taken into consideration, the unbiased prediction of the forward discounted rate is recovered to some extent in a theoretically consistent manner.
Abstract: This paper empirically examines whether the interaction between foreign exchange markets and monetary markets can help to resolve the forward discount puzzle. Following the monetary models of Lucas (1990) and Fuerst (1992), we define as liquidity effects (the negative impact of monetary injection on nominal interest rates), temporary deviations from the standard Euler equation. The liquidity effect identified by these models weakens the linkage between current forward rates and expected future spot rates, and improves on the standard rational expectations model that predicts a one-to-one correspondence between the two. Using time series of exchange rates among the United States, Canada, and Japan, this paper shows that the liquidity measure identified above has an impact on forward premiums, and that once the liquidity effect is taken into consideration, the unbiased prediction of the forward discount rate is recovered to some extent in a theoretically consistent manner.

18 citations

Posted Content
TL;DR: This article examined the trade-off between exchange rate stability and monetary autonomy for a target zone and found that the narrow guilder-mark target zone still permitted a modest degree of policy independence.
Abstract: This paper examines the trade-off between exchange rate stability and monetary autonomy for a target zone. Using the guilder-mark target zone in the pre-EMU period as a case study, we empirically estimate how much policy discretion the Dutch central bank still enjoyed and how much had been ceded to the German central bank. The sum of these two measures is an estimate of the policy autonomy under a free float. We find that the narrow guilder-mark target zone still permitted a modest degree of policy independence. This result suggests that intermediate exchange rate regimes may offer an attractive trade-off compared to the corner solutions (free float and monetary union), which is consistent with the ‘fear of floating’ phenomenon.

5 citations

Journal ArticleDOI
TL;DR: In this article, the authors test the validity of a Forward Discount Bias Puzzle in a small open developing economy (SODE) by employing first an unstructured vector autoregression (VAR) model and then a structured VAR model.
Abstract: This article tests the validity of a Forward Discount Bias Puzzle, in a small open developing economy (SODE)—Sri Lanka—by employing first an unstructured vector autoregression (VAR) model and then a structured VAR model. The author argues that empirical examinations concerning SODEs cannot merely replicate methodology followed in testing developed economies, and identifies the need to disentangle capital flows from interest rate changes by including both capital flow and monetary policy variables. The article finds no evidence of a Forward Discount Bias Puzzle in Sri Lanka, and that perfect capital mobility is a too strong assumption. Hence, it proves that empirically more appropriate approach is to assume some capital mobility and incorporate capital flow data to accommodate for this change, in the analysis of UIRP.

4 citations


Cites methods from "The Effect of Monetary Policy on Ex..."

  • ...This puzzle was subsequently partially resolved by Kumah (1996) and completely resolved by Kim and Roubini (2000) by adopting an SVAR approach instead of the UVAR....

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Posted Content
TL;DR: In this article, the effects of a contractionary Dutch monetary policy shock that is consistent with the fixed guilder/mark exchange rate were analyzed, showing that monetary policy shocks account for non-negligible parts of the forecast error variance of macroeconomic variables.
Abstract: We analyze the effects of a contractionary Dutch monetary policy shock that is consistent with the fixed guilder/mark exchange rate. Although monetary policy shocks are quite small, they do have plausible effects: credit, expenditures, output and prices all fall after a monetary tightening. Policy shocks account for non-negligible parts of the forecast error variance of macroeconomic variables. EMU membership thus entails a non-trivial sacrifice in terms of macroeconomic stabilization - even for the Netherlands, which many deemed to be in a quasi monetary union with Germany.

2 citations


Cites background from "The Effect of Monetary Policy on Ex..."

  • ...See Kumah (1996) and Smets (1997) for a discussion. 18 The ‘price puzzle’ refers to the finding that the price level rises following a monetary policy tightening. See Sims (1992) and Christiano, Eichenbaum and Evans (1996) for a discussion....

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  • ...See Kumah (1996) and Smets (1997) for a discussion....

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References
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Journal ArticleDOI
TL;DR: In this paper, the authors developed a theory of exchange rate movements under perfect capital mobility, a slow adjustment of goods markets relative to asset markets, and consistent expectations, and showed that along that path a monetary expansion causes the exchange rate to depreciate.
Abstract: The paper develops a theory of exchange rate movements under perfect capital mobility, a slow adjustment of goods markets relative to asset markets, and consistent expectations. The perfect foresight path is derived and it is shown that along that path a monetary expansion causes the exchange rate to depreciate. An initial overshooting of exchange rates is shown to derive from the differential adjustment speed of markets. The magnitude and persistence of the overshooting is developed in terms of the structural parameters of the model. To the extent that output responds to a monetary expansion in the short run, this acts as a dampening effect on exchange depreciation and may, in fact, lead to an increase in interest rates.

4,766 citations


"The Effect of Monetary Policy on Ex..." refers background or methods in this paper

  • ...The monetary approach to exchange rate modelling encompasses both sticky-price models (of Dornbusch(1976) for instance) and flexible price models....

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  • ...…federal funds rate and - following the predictions of asset-market-based models of exchange rate determination (the overshooting sticky-price model of Dornbusch(1976) for instance) - to, ceteris paribus , depreciate the dollar on impact just as a contractionary foreign monetary policy shock would....

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Posted Content
TL;DR: The authors showed that the interest rate on the Federal Funds is extremely informative about future movements of real macroeconomic variables, more so than monetary aggregates or other interest rates, and argued that the reason for this forecasting is that the funds rate sensitively records shocks to the supply of (not the demand for) bank reserves.
Abstract: First, we show that the interest rate on Federal funds is extremely informative about future movements of real macroeconomic variables, more so than monetary aggregates or other interest rates. Next, we argue that the reason for this forecasting is that the funds rate sensitively records shocks to the supply of (not the demand for) bank reserves, i.e. the funds rate is a good indicator of monetary policy actions. Finally, using innovations to the fuels rate as a measure of changes in monetary policy, we present evidence consistent with the view that monetary policy works at least in part through "credit" (that is, bank loans) as well as through "money" (that is, bank deposits) - even though bank loans fail to Granger-cause real variables.

3,027 citations


"The Effect of Monetary Policy on Ex..." refers background or methods in this paper

  • ...Bernanke and Blinder(1992) argue for the use of innovations to the federal funds rate as monetary innovations....

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  • ...Following Bernanke and Blinder(1992) we assume that monetary policy variables respond contemporaneously to innovations in domestic macroeconomic variables - this is to say that monetary authorities have contemporaneous information on the state of the economy....

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  • ...Their identification scheme encompasses those of Bernanke and Blinder(1992), Christiano et al(1992) and Strongin(1995)....

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  • ...Bernanke and Mihov also show that the identification schemes of Bernanke and Blinder(1992) as well as that of Christiano et al ....

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  • ...In a search for a solution to this puzzle Bernanke and Blinder(1992) as well as Sims(1992) identify monetary policy shocks directly with innovations in interest rates....

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Posted Content
TL;DR: The authors developed a "demi-structural" VAR approach, which extracts information about monetary policy from data on bank reserves and the federal funds rate but leaves the relationships among the macroeconomic variables in the system unrestricted.
Abstract: Extending the approach of Bernanke and Blinder (1992), Strongin (1992), and Christano, Eichenbaum, and Evans (1994a, 1994b), we develop and apply a VAR-based methodology for measuring the stance of monetary policy. More specifically, we develop a "demi-structural" VAR approach, which extracts information about monetary policy from data on bank reserves and the federal funds rate but leaves the relationships among the macroeconomic variables in the system unrestricted. The methodology can be used to compare and evaluate existing indicators of monetary policy and also to develop an "optimal" measure (given our framework). Among existing approaches, we find that innovations to the federal funds rate (Bernanke-Blinder) are a good measure of policy innovations during the periods 1965-1979 and 1988-1994; for the period 1979-1994 as a whole, innovations to the orthogonalized component of nonborrowed reserve (Strongin) seems to be the best choice. The new measure of policy stance that we develop conforms well to qualitative indicators of policy such as the Boschen-Mills (1991) index; and innovations to our measure lead to reasonable and precisely estimated dynamic responses by variables such as real GDP and the GDP deflator.

1,503 citations

ReportDOI
TL;DR: The authors used a long-run restriction implied by a large class of real-business-cycle models -identifying permanent productivity shocks as shocks to the common stochastic trend in output, consumption, and investment -to provide new evidence on this question.
Abstract: Are business cycles mainly the result of permanent shocks to productivity? This paper uses a long-run restriction implied by a large class of real-business-cycle models -identifying permanent productivity shocks as shocks to the common stochastic trend in output, consumption, and investment -to provide new evidence on this question. Econometric tests indicate that this common-stochastic-trend / cointegration implication is consistent with postwar U.S. data. However, in systems with nominal variables, the estimates of this common stochastic trend indicate that permanent productivity shocks typically explain less than half of the business-cycle variability in output, consumption, and investment. (JEL E32, C32) A central, surprising, and controversial result of some current research on real business cycles is the claim that a common stochastic trend-the cumulative effect of permanent shocks to productivity-underlies the bulk of economic fluctuations. If confirmed, this finding would imply that many other forces have been relatively unimportant over historical business cycles, including the monetary and fiscal policy shocks stressed in traditional macroeconomic analysis. This paper shows that the hypothesis of a common stochastic productivity trend has a set of econometric implications that allows us to test for its presence, measure its importance, and extract estimates of its realized value. Applying these procedures to consumption, investment, and output for the postwar United States, we find results that both support and contradict this claim in the real-businesscycle literature. The U.S. data are consistent with the presence of a common

1,437 citations