Monetary policy's role in exchange rate behavior

Abstract

We address the role of monetary policy shocks in exchange rate behavior using an inference procedure that allows us to relax dubious identifying assumptions. We find: (i) The peak exchange rate response may be delayed or nearly immediate; (ii) In every otherwise reasonable identification, monetary policy shocks lead to large uncovered interest rate parity (UIP) deviations; (iii) Monetary policy shocks may account for a smaller portion of exchange rate variance than found earlier. While (i) is consistent with overshooting, (ii) implies that the overshooting cannot be driven by Dornbusch's mechanism, and (iii) casts doubt on monetary policy shocks being the main source of exchange rate volatility.