Dornbusch's overshooting hypothesis revisited

Currencies are volatile and prone to "overshooting" (going above or below their expected ranges). Rudiger Dornbusch’s (1976) well known exchange rate overshooting states that the nominal exchange rate immediately appreciates with the increase in nominal interest rates, in line with uncovered interest parity (UIP). The problem is, many recent studies suggest otherwise.  As Hilde C. Bjørnland of the University of Oslo writes:

Instead they have found that following a contractionary monetary policy shock, the real exchange rate either depreciates, or, if it appreciates, it does so for a prolonged period of up to three years, thereby giving a hump-shaped response that violates UIP. These results have been so persuasive that the puzzles themselves are now about to be considered consensus, of which many recently developed DSGE models seek to replicate.

In Norges Bank working paper 2005/11, Monetary policy and the illusionary exchange rate puzzle (PDF), she argues there is amajor problem with VAR modesl used. They ignore the immediate effects of a monetary shock on the exchange rate:

The majority of studies quantifying the effects of monetary policy shocks have used the vector autoregressive (VAR) approach. A major problem facing these studies is how to address the simultaneity of monetary policy and the exchange rate. Most of the studies of open economies are placing zero contemporaneous restrictions on the response of the systematic interest rate setting to an exchange rate shock, or vice versa. However, this is not consistent with established theory neither on monetary policy nor on exchange rate determination. Furthermore, Faust and Rogers (2003) have recently shown that the delayed overshooting feature of the open economy VAR is very sensitive to this kind of restriction. VAR models of the open economy should therefore seek to identify monetary policy without restricting the contemporaneous response.

Her modelling suggests the Dornbusch hypothesis can be reconciled with the empirical data, if one "restricts the long run multipliers of the shocks, but leaves the contemporaneous relationship between the interest rate and the exchange rate unaltered". That is, she leaves "monetary policy ..free to influence the exchange rate".

Allowing for full simultaneity between monetary policy and the exchange rate, I find striking results; Contrary to the recent “consensus”, a contractionary monetary policy shock has a strong effect on the exchange rate that appreciates on impact. The maximal impact occurs immediately, and the exchange rate thereafter gradually depreciates back to baseline. This is consistent with the Dornbusch overshooting hypothesis. Furthermore, the ensuing movement of the exchange rate is with few exceptions consistent with UIP. Hence, I have found no evidence of the typical hump-shaped response found in the empirical literature, where the maximal impact occurs after 2-3 years...

To better understand these arguments, I suggest you open up the paper and compare the charts in Figure 1 with those in subsequent figures.

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