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Dornbusch Overshooting, UIP, and the Systematic Components of Domestic and Foreign Monetary Policy in SVARs

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  • Nicolas Groshenny
  • Naveed Javed

Abstract

We highlight the importance of jointly identifying domestic and foreign monetary shocks in SVAR-based evaluations of Dornbusch exchange rate overshooting and uncovered interest parity (UIP) in small open economies (SOEs). We estimate SVAR models for six developed SOEs to understand the effects of SOE and US monetary policy shocks on bilateral SOE/US exchange rates. Our novel identification strategy features block exogeneity combined with sign restrictions imposed on the coefficients of the SOE and US monetary policy rules. Crucially, the response of the exchange rate to monetary shocks is not restricted, and the SOE policy rate and the exchange rate are allowed to interact instantaneously. Exchange rate dynamics triggered by monetary shocks are found to be broadly in line with Dornbusch overshooting and UIP. We demonstrate that the few cases in which US monetary shocks trigger delayed overshooting in specific samples may not be inconsistent with UIP, but rather an artifact of SOE endogenous monetary policy responses to the US policy rate.

Suggested Citation

  • Nicolas Groshenny & Naveed Javed, 2025. "Dornbusch Overshooting, UIP, and the Systematic Components of Domestic and Foreign Monetary Policy in SVARs," CAMA Working Papers 2025-06, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    • Handle: RePEc:een:camaaa:2025-06
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    More about this item

    Keywords

    structural vector autoregressions; small open economies; monetary policy shocks; exchange rates; delayed overshooting; uncovered interest rate parity; spillovers of US monetary policy;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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