Dornbusch Overshooting, UIP, and the Systematic Components of Domestic and Foreign Monetary Policy in SVARs

We highlight the importance of jointly identifying domestic and foreign monetary shocks in SVAR-based evaluations of Dornbusch exchange rate overshooting and uncovered interest parity (UIP) in small open economies (SOEs). We estimate SVAR models for six developed SOEs to understand the effects of SOE and US monetary policy shocks on bilateral SOE/US exchange rates. Our novel identification strategy features block exogeneity combined with sign restrictions imposed on the coefficients of the SOE and US monetary policy rules. Crucially, the response of the exchange rate to monetary shocks is not restricted, and the SOE policy rate and the exchange rate are allowed to interact instantaneously. Exchange rate dynamics triggered by monetary shocks are found to be broadly in line with Dornbusch overshooting and UIP. We demonstrate that the few cases in which US monetary shocks trigger delayed overshooting in specific samples may not be inconsistent with UIP, but rather an artifact of SOE endogenous monetary policy responses to the US policy rate.