Effects of monetary policy shocks on exchange rate in small open Economies

Abstract

This study empirically investigates the effects of monetary policy shocks on exchange rates in four small open economies (United Kingdom, Canada, Sweden, and Australia) by using VAR models in which sign restrictions on impulse responses are imposed to identify monetary policy shocks. The main empirical findings are as follows. (1) A contractionary monetary policy leads to significant exchange rate appreciation. (2) The delay in overshooting is relatively short, at best six months. (3) The deviation from the UIP condition is relatively small, although significant at short horizons in a few cases. To obtain results without strong puzzles, constructing an empirical model that reflects the features of the small open economy and estimates the model for the recent inflation-targeting period during which monetary policy operating procedure does not change substantially are important.