Monetary policy and exchange rate response: evidence from shock-restricted SVAR with uncertainty measures

Abstract We examine the response of the exchange rate to monetary policy shocks using structural vector autoregression (SVAR). The SVAR approach in this study differs from previous studies by incorporating uncertainty measures and employing shock-restricted identification constraints. Using structural shocks that are in accordance with the event and external variable constraints, we demonstrate that the US exchange rate appreciates immediately in response to contractionary monetary policy shocks, with the maximum appreciation occurring within one to two months. Our finding highlights the importance of allowing contemporaneous interaction between interest rate and exchange rate, as facilitated by the shock-restricted SVAR, and accounting for uncertainties to address the puzzle of the exchange rate response.