Exchange rate dynamics and monetary policy: Evidence from a non-linear DSGE-VAR approach

Publication: Working/Discussion PaperWU Working Paper

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Abstract

In this paper, we reconsider the question how monetary policy influences exchange rate dynamics. To this end, a vector autoregressive (VAR) model is combined with a two-country dynamic stochastic general equilibrium (DSGE) model. Instead of focusing exclusively on how monetary policy shocks affect the level of exchange rates, we also analyze how they impact exchange rate volatility. Since exchange rate volatility is not observed, we estimate it alongside the remaining quantities in the model. Our findings can be summarized as follows. Contractionary monetary policy shocks lead to an appreciation of the home currency, with exchange rate responses in the short-run typically undershooting their long-run level of appreciation. They also lead to an increase in exchange rate volatility. Historical and forecast error variance decompositions indicate that monetary policy shocks explain an appreciable amount of exchange rate movements and the corresponding volatility.
Original languageEnglish
Number of pages42
DOIs
Publication statusPublished - 2019

Publication series

SeriesDepartment of Economics Working Paper Series
Number295

Austrian Classification of Fields of Science and Technology (ÖFOS)

  • 502046 Economic policy
  • 502047 Economic theory
  • 502018 Macroeconomics

WU Working Paper Series

  • Department of Economics Working Paper Series

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