Monetary Policy, Foreign Exchange Policy, and Delayed Overshooting

By Kim, Soyoung | Journal of Money, Credit & Banking, August 2005 | Go to article overview

Monetary Policy, Foreign Exchange Policy, and Delayed Overshooting


Kim, Soyoung, Journal of Money, Credit & Banking


PAST STUDIES (e.g., Eichenbaum and Evans, 1995 for the U.S. and Grilli and Roubini, 1995 for non-U.S. G-7 countries) documented a puzzling response of the exchange rate to monetary policy shocks. They report that (contractionary) monetary policy shocks lead gradual appreciation of the exchange rate, followed by gradual depreciation; the maximum appreciation is not found on impact but it is found only in delay. Such responses are not consistent with the traditional open economy sticky price model such as Dornbusch (1976) and the uncovered interest parity condition, and called "delayed overshooting" puzzle.

Some past studies suggested that the puzzle may be due to the problematic identifying assumptions, and the results are more consistent with the theory when more plausible identifying assumptions are used. Eichenbaum and Evans (1995) and Grilli and Roubini (1995) obtained the puzzling result by using VAR models with recursive short-run zero restrictions. However, Cushman and Zha (1997), Kim and Roubini (2000), and Faust and Rogers (2003) used VAR models with non-recursive short-run zero restrictions and Jang and Ogaki (2004) used a structural VECM with long run restrictions, and these studies provide more consistent results.

In contrast to these past studies that tend to treat the delayed overshooting puzzle as a possibly incorrect empirical fact, this paper regards the puzzling observation as a plausible empirical fact, and seeks for an explanation based on foreign exchange policy's reaction to monetary policy. In response to a contractionary monetary policy shocks, the exchange rate appreciates, but the foreign exchange policy mitigates the appreciation initially as "leaning-against-the-wind" intervention, so that the impact appreciation becomes weak. When the effect of the foreign exchange policy on the exchange rate is short-lived but the effect of monetary policy is more prolonged, the exchange rate may further appreciate as the effect of the foreign exchange policy disappears, and the maximum effect is only found in delay.

This paper uses Canadian data to support such an explanation. Canadian policies closely monitor the exchange rate against the U.S. dollars. For Canada, the U.S. dollar foreign exchange reserve data is available, which is crucial to identify foreign exchange policy against the U.S. Therefore, Canadian data is useful in examining the interactions among monetary and foreign exchange policies and the exchange rate against the U.S. dollar, and in studying the relevance of the above explanation on the delayed overshooting puzzle. Section 1 explains the empirical model; Section 2 discusses the empirical results; and Section 3 concludes.

1. EMPIRICAL MODEL

The structural VAR model with zero restrictions on contemporaneous structural parameters is used to examine the issue, following past studies on the effects of monetary policy shocks on the exchange rate such as Eichenbaum and Evans (1995), Grilli and Roubini (1995), Kim and Roubini (2000), and Kim (2003). I skip the detailed estimation method on the structural VAR model with zero restrictions on contemporaneous structural parameters since it is well-documented in the past studies. (1)

The empirical model is constructed to focus on the interactions among Canadian monetary and foreign exchange policies and the exchange rate of the Canadian Dollar against the U.S. Dollar. The data vector is {FR, R, M, CPI, IP, E(C$/$), FFR}, where FR is the Bank of Canada's U.S. Dollar foreign exchange reserve, R is the Canadian short-term interest rate, M is the Canadian monetary aggregate, CPI is the Canadian consumer price index, IP is the Canadian industrial production index, E(C$/$) is the exchange rate of Canadian Dollar against the U.S. Dollar (the Canadian Dollar price of one unit of the U.S. Dollar), and FFR is the U.S. Federal Funds Rate. (2)

The interest rate, money, price, and output are well-known variables in monetary business cycle literature. …

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