1 Introduction
What are the effects of monetary policy on exchange rates? According to
conventional wisdom, there is a sharp conflict between baseline theory and
baseline evidence. Dornbusch’s (1976) well known overshooting hypothesis
predicts that an increase in domestic interest rates relative to foreign interest
rates leads to an impact appreciation followed by a persistent depreciation
of the domestic currency.
Empirical studies have found different results, however. The most suc-
cessful studies have followed the lead of Sims (1972, 1980), employing vector
autoregressions to study these issues in order to sort out the issues of causal-
ity of monetary policy shocks. Among the advantages of this methodology
is the possibility to cleanly formulate and understand the impact of policy
changes without violations of the Lucas’ critique, see Sims (1982, 1986).
For the issue of the effects of monetary policy on exchange rates, e.g.
Eichenbaum and Evans (1995) and Grilli and Roubini (1995, 1996) employ
recursive identification and find a persistent appreciation for periods up to
three years, in contrast to theory. Also Leeper, Sims and Zha (1996) find
this result for their larger specifications, although it is not the main focus
there. This finding is known as the ’delayed overshooting puzzle’, see fig-
ure 1. In particular, this implies a violation of the uncovered interest parity
(UIP) condition, and is therefore also often called the ’forward discount puz-
zle’, see figure 2. Note that there may be a forward discount puzzle even
without delayed overshooting. Moreover, monetary contractions in the sev-
eral G-7 countries lead to an impact depreciation or, at least, no significant
appreciation of their currencies relative to the US dollar (Sims, 1992, Grilli
and Roubini 1995, 1996). This is known as the ’exchange rate puzzle’, see
figure 3. In addition, the quantitative effect of monetary policy on exchange
rates is far from being clear. The estimated percentages of exchange rate
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