Discussion Paper Details

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Title: Exchange Rate Undershooting: Evidence and Theory

Author(s): Thomas Hettig, Gernot Müller and Martin Wolf

Publication Date: March 2019

Keyword(s): Forward Exchange Rate, Forward premium puzzle, information effect, Information Frictions, monetary policy, Spot Exchange Rate and UIP puzzle

Programme Area(s): International Macroeconomics and Finance

Abstract: We run local projections to estimate the effect of US monetary policy shocks on the dollar. We find that monetary contractions appreciate the dollar and establish two results. First, the spot exchange rate undershoots: the appreciation is smaller on impact than in the longer run. Second, forward exchange rates also appreciate on impact, but their response is flat across tenors. Next, we develop and estimate a New Keynesian model with information frictions. In the model, investors do not observe the natural rate of interest directly. As a result, they learn only over time whether an interest rate surprise represents a monetary contraction. The model accurately predicts the joint dynamics of spot and forward exchange rates following a monetary contraction.

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Bibliographic Reference

Hettig, T, Müller, G and Wolf, M. 2019. 'Exchange Rate Undershooting: Evidence and Theory'. London, Centre for Economic Policy Research.