New Evidence on the Puzzles. Results from Agnostic Identification on Monetary Policy and Exchange Rates.

Abstract

Past empirical research on monetary policy in open economies has
found evidence of the ’delayed overshooting’, the ’forward discount’
and the ’exchange rate’ puzzles. We revisit the effects of monetary pol-
icy on exchange rates by applying Uhlig’s (2005) identification proce-
dure that involves sign restrictions on the impulse responses of selected
variables. We impose no restrictions on the exchange rate to leave
the key question as open as possible. The sign restriction methodol-
ogy avoids the “price puzzles” of the identification strategies used by
Eichenbaum-Evans (1995) and by Grilli-Roubini (1995, 1996), which
are particularly pronounced, when using an updated data set. We find
that the puzzles regarding the exchange rates are still there, but that
the quantitative features are different. In response to US monetary
policy shocks, the peak appreciation happens during the first year af-
ter the shock for the US-German and the US-UK pair, and during
the first two years for the US-Japan pair. This is consirably quicker
than the three-year horizon found by Eichenbaum-Evans. There is a
robust forward discount puzzle implying a large risk premium. We
study this issue, introducing and calculating conditional Sharpe ra-
tios for a Bayesian investor investing in a hedged position following
a US monetary policy shock. For foreign monetary policy shocks, we
find more robust results than with the Grilli-Roubini recursive iden-
tification strategy: the posterior distribution regarding the exchange
reaction looks rather similar across countries and VAR specifications.
In particular, we find that there seems to be considerable uncertainty
regarding the initial reaction of the exchange rate. Quantitatively,
monetary policy shocks seem to have a minor impact on exchange
rate fluctuations.

Keywords: vector autoregressions, agnostic identification, forward dis-
count bias puzzle, exchange rate puzzle, exchange rates, monetary policy

JEL codes: C32, E58, F31, F42

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