Working Paper: NBER ID: w25021
Authors: Atsushi Inoue; Barbara Rossi
Abstract: What are the effects of monetary policy on exchange rates? And have unconventional monetary policies changed the way monetary policy is transmitted to international financial markets? According to conventional wisdom, expansionary monetary policy shocks in a country lead to that country's currency depreciation. We revisit the conventional wisdom during both conventional and unconventional monetary policy periods in the US by using a novel identification procedure that defines monetary policy shocks as changes in the whole yield curve due to unanticipated monetary policy moves and allows monetary policy shocks to differ depending on how they affect agents' expectations about the future path of interest rates as well as their perceived effects on the riskiness/uncertainty in the economy. Our empirical results show that: (i) a monetary policy easing leads to a depreciation of the country's spot nominal exchange rate in both conventional and unconventional periods; (ii) however, there is substantial heterogeneity in monetary policy shocks over time and their effects depend on the way they affect agents' expectations; (iii) we find favorable evidence to Dornbusch's (1976) overshooting hypothesis.
Keywords: Monetary Policy; Exchange Rates; Unconventional Monetary Policy
JEL Codes: C22; C53; F31; F37
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary policy easing (E52) | Depreciation of nominal exchange rate (F31) |
| Monetary policy shocks (E39) | Heterogeneity in effects over time (C22) |
| Monetary policy shock (E39) | Changes in expectations about future interest rates (E43) |
| Monetary policy shock (E39) | Perceived economic risk (D81) |
| Monetary policy shock (E39) | Overshooting of exchange rates (F31) |