Permanent and temporary monetary policy shocks and the dynamics of exchange rates

This paper asks whether different types of nominal disturbances affect exchange rates differently and whether such distinction helps understanding the short-run and long-run relations between nominal rates and exchange rates, in a context where nominal disturbances are typically seen as important drivers of exchange rate movements. Our empirical exercise relies on monthly data for exchange rates, inflation, nominal interest rates and output from 1971 to 2019, considering the U.S. and another advanced economy among the following: Great Britain, Germany, France, Australia, Switzerland, Japan and the euro area.
In sum, we find that a shock leading to a temporary increase in U.S. nominal interest rates leads to a temporary appreciation of the USD against the other currencies. In turn, a monetary policy shock leading to a permanent rise in nominal interest rates – e.g., one associated with a normalisation of monetary policy after a long period at the zero lower bound – results in a depreciation of the USD, in the short as well as over the long run that may contribute to higher (not lower) inflation also in the short run.
The tables and figures of this paper present the results of the estimation of the VECM and the impulse response functions as well as the FEVD.