Effects of Monetary Policy on the US Dollar/UK Pound Exchange Rate. Is There a "Delayed Overshooting Puzzle"?

Heinlein, Reinhold; Krolzig, Hans Martin

Abstract

The determination of the US dollar/UK pound sterling exchange rate is studied in a small symmetric macroeconometric model including UK-US differentials in inflation, output gap, and short- and long-term interest rates for the four decades since the breakdown of Bretton Woods. The key question addressed is the possible presence of a "delayed overshooting puzzle" in the dynamic reaction of the exchange rate to monetary policy shocks. In contrast to the existing literature, we follow a data-driven modeling approach combining (i) a vector autoregression (VAR)-based cointegration analysis with (ii) a graph-theoretic search for instantaneous causal relations and (iii) an automatic general-to-specific approach for the selection of a congruent parsimonious structural vector equilibrium correction model. We find that the long-run properties of the system are characterized by four cointegration relations and one stochastic trend, which is identified as the long-term interest rate differential and that appears to be driven by long-term inflation expectations as in the Fisher hypothesis. It cointegrates with the inflation differential to a stationary "real" long-term rate differential and also drives the exchange rate. The short-run dynamics are characterized by a direct link from the short-term to the long-term interest rate differential. Jumps in the exchange rate after short-term interest rate variations are only significant at 10%. Overall, we find strong evidence for delayed overshooting and violations of uncovered interest rate parity (UIP) in response to monetary policy shocks. © 2012 Blackwell Publishing Ltd.

• Journal Article Type: Article
• Online Publication Date: Jul 16, 2012
• Publication Date: Aug 1, 2012
• Deposit Date: Sep 18, 2019
• Publicly Available Date: Sep 19, 2019
• Journal: Review of International Economics
• Print ISSN: 0965-7576
• Electronic ISSN: 1467-9396
• Publisher: Wiley
• Peer Reviewed: Peer Reviewed
• Volume: 20
• Issue: 3
• Pages: 443-467
• DOI: https://doi.org/10.1111/j.1467-9396.2012.01033.x
• Public URL: https://uwe-repository.worktribe.com/output/2718310
• Contract Date: Sep 18, 2019