Does the Exchange Rate Depend upon Relative Monetary Policies?

In this paper we consider the evidence of liquidity effects on the exchange rate. We consider VAR systems for the U.S. and Euro-area and found that while innovations in US. monetary poiicy lead to the expected depreciation (appreciation) of the U.S. dollar, positive innovations to the Euro-area interest rates associated with an impact depreciation of the Euro. We offered an explanation for this ‘exchange rate puzzie”. The innovation in the Euro-area occurs as an endogenous policy reaction to underlying inflationary shocks, which causes the Euro depreciation. After controlling for expected inflation, the interest rates innovation leads to a persistent currency appreciation.