Effects of Monetary Policy on the US Dollar/UK Pound Exchange Rate. Is There a “Delayed Overshooting Puzzle”?

Abstract

Abstract The determination of the US dollar/UK pound sterling exchange rate is studied in a small symmetric macroeconometric model including UK–US differentials in inflation, output gap, and short‐ and long‐term interest rates for the four decades since the breakdown of Bretton Woods. The key question addressed is the possible presence of a “delayed overshooting puzzle” in the dynamic reaction of the exchange rate to monetary policy shocks. In contrast to the existing literature, we follow a data‐driven modeling approach combining (i) a vector autoregression (VAR)‐based cointegration analysis with (ii) a graph‐theoretic search for instantaneous causal relations and (iii) an automatic general‐to‐specific approach for the selection of a congruent parsimonious structural vector equilibrium correction model. We find that the long‐run properties of the system are characterized by four cointegration relations and one stochastic trend, which is identified as the long‐term interest rate differential and that appears to be driven by long‐term inflation expectations as in the Fisher hypothesis. It cointegrates with the inflation differential to a stationary “real” long‐term rate differential and also drives the exchange rate. The short‐run dynamics are characterized by a direct link from the short‐term to the long‐term interest rate differential. Jumps in the exchange rate after short‐term interest rate variations are only significant at 10%. Overall, we find strong evidence for delayed overshooting and violations of uncovered interest rate parity (UIP) in response to monetary policy shocks.

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