New Evidence on the Puzzles: Monetary Policy and Exchange Rates

Past empirical research on monetary policy in open economies has found the “delayed overshooting†, the “forward discount†and the “exchange rate†puzzles. We revisit the effects of monetary policy on exchange rates by applying Uhlig's (2005) identification procedure 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. Importantly, our identification scheme avoids the “price puzzle†. We find that the puzzles regarding the exchange rate 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 after the shock for the US-UK and the US-Japan country pair and during the first two years for the US-Germany country pair. There is a robust forward discount puzzle implying a large risk premium. We study this issue by calculating conditional Sharpe ratios for a Bayesian investor investing in a hedged position following a US monetary policy shock. For foreign monetary policy shocks, we find a considerable uncertainty regarding the initial reaction of the exchange rate. Quantitatively, monetary policy shocks seem to have a minor impact on exchange rate fluctuations