Monetary Policy Shocks and Exchange Rate Dynamics in Small Open Economies

ABSTRACT This paper investigates whether the effects of monetary policy shocks on real exchange rates have changed over time and, if so, whether these changes stem from shifts in transmission mechanisms or from variation in the volatility of the shocks themselves. Using a time‐varying parameter VAR with stochastic volatility for six small open economies, we first show that a constant‐parameter VAR with stochastic volatility provides the best fit to the data in all six cases. We then employ an identification strategy that combines short‐ and long‐run restrictions to isolate monetary policy shocks, and we evaluate its robustness using high‐frequency monetary policy surprises as external instruments. Our results support Dornbusch's overshooting hypothesis in most countries. However, uncovered interest parity is frequently violated, as foreign excess returns diverge from zero following monetary policy shocks. Finally, we document a substantial decline in the volatility of monetary policy shocks since the 1990s, leading to a reduced contribution to exchange rate and macroeconomic fluctuations.

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Publication Details

Journal
Journal of Applied Econometrics
Published
2026-03-11
DOI
https://doi.org/10.1002/jae.70051
Primary Topic
Monetary Policy and Economic Impact
Type
article
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article

Monetary Policy Shocks and Exchange Rate Dynamics in Small Open Economies

J. J. Cross, Madison Terrell, Firmin Doko Tchatoka, Qazi Haque
Journal of Applied Econometrics
Monetary Policy and Economic Impact
article

Monetary Policy Shocks and Exchange Rate Dynamics in Small Open Economies

J. J. Cross, Madison Terrell, Firmin Doko Tchatoka, Qazi Haque
article en

Abstract

ABSTRACT This paper investigates whether the effects of monetary policy shocks on real exchange rates have changed over time and, if so, whether these changes stem from shifts in transmission mechanisms or from variation in the volatility of the shocks themselves. Using a time‐varying parameter VAR with stochastic volatility for six small open economies, we first show that a constant‐parameter VAR with stochastic volatility provides the best fit to the data in all six cases. We then employ an identification strategy that combines short‐ and long‐run restrictions to isolate monetary policy shocks, and we evaluate its robustness using high‐frequency monetary policy surprises as external instruments. Our results support Dornbusch's overshooting hypothesis in most countries. However, uncovered interest parity is frequently violated, as foreign excess returns diverge from zero following monetary policy shocks. Finally, we document a substantial decline in the volatility of monetary policy shocks since the 1990s, leading to a reduced contribution to exchange rate and macroeconomic fluctuations.

Journal of Applied Econometrics
Australian National University (AU), The University of Melbourne (AU), UCL Australia (AU), Victorian Curriculum and Assessment Authority (AU), Melbourne School of Theology (AU), Reserve Bank of Australia (AU), University of Oxford (GB), Centre for Australian National Biodiversity Research (AU), The University of Adelaide (AU)
Openalex Percentile: Top 29%
Monetary Policy and Economic Impact
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