New working paper

This paper examines how an unanticipated tightening of a central bank’s policy stance affects the real exchange rate. A vast empirical literature using vector autoregressions (VARs) has produced mixed findings, including appreciations, depreciations, and immediate or delayed exchange rate adjustments after contractionary monetary policy interventions. The present paper demonstrates that this divergence of results likely stems from (i) the assumptions used to make causal interpretations of the estimated economic relationships possible; and from (ii) the informational content of the regression models themselves. In particular, it suggests that more evidence than previously thought may align with canonical economic theory, particularly the open-economy dynamic stochastic general equilibrium (DSGE) framework.  

A key prediction of this model class is exchange rate “overshooting:” the combination of uncovered interest rate parity and purchasing power parity causes an immediate real appreciation after an interest rate hike, which then gradually reverts. Deviations from this benchmark have been interpreted as “puzzles,” challenging conventional open-economy theory.

Rather than offering another empirical estimate, this paper uses a prototypical open-economy DSGE model as its laboratory. First, this puzzle-free model is summarized via a typical VAR featuring a small set of model-consistent time series. Next, state-of-the-art identification strategies are applied to isolate so-called monetary policy “shocks” and to analyze their international transmission. The key findings are: identification strategies that reveal counterfactual depreciation or delayed exchange rate adjustment in real data do the same in the controlled setup, while identifications that tend to support theory in empirical work identify model-consistent real exchange rate movements in the simulation design.

Finally, the paper addresses a closely related open-economy anomaly: the failure of uncovered interest rate parity after an interest rate surprise. Empirical studies often show domestic investors earning risk-free excess returns after a domestic policy tightening, violating uncovered interest rate parity. The paper shows that even when relying on ideal assumptions for structural identification, minor informational deficiencies in the estimation of broader economic relationships suffice to spuriously reject uncovered interest rate parity, thus highlighting the central role of VAR “invertibility” in empirical work on open-economy phenomena.

Taken together, the findings of the paper suggest that disagreement across the empirical literature on exchange rate overshooting may be smaller than previously thought, and evidence hitherto seen as challenging may actually support canonical open-economy theory.