Exchange Rates and Uncovered Interest Differentials: The Role of Permanent Monetary Shocks
We estimate an empirical model of exchange rates with transitory and permanent monetary shocks. Using monthly post-Bretton-Woods data from the United States, the United Kingdom, and Japan, we report four main findings: First, there is no exchange rate overshooting in response to either temporary or permanent monetary shocks. Second, a transitory increase in the nominal interest rate causes appreciation, whereas a permanent increase in the interest rate causes short-run depreciation. Third, transitory increases in the interest rate cause short-run deviations from uncovered interest-rate parity in favor of domestic assets, whereas permanent increases cause deviations against domestic assets. Fourth, permanent monetary shocks explain the majority of short-run movements in nominal exchange rates.
We thank seminar participants at Wharton, Royal Holloway, Stockholm University, and the HeiTüHo Workshop on International Financial Markets held in Tübingen for comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.