Exchange Rate Overshooting: A Reassessment in a Monetary Framework

Most empirical studies on monetary policies have found exchange rate effects that are inconsistent with Dornbusch's overshooting hypothesis. Bjornland (2009) finds evidence of exchange rate overshooting by using interest rate alone as the monetary policy instrument. However, theoretically consistent way of identifying monetary policy requires capturing dual interaction between central bank's reaction to economic conditions and private sector's response to policy action. This calls for the introduction of "monetary‟ aggregates back in the models of exchange rate determination. Motivated by Bjornland's result, identification is achieved by imposing short-run and long-run restrictions while keeping the short-run interactions between monetary policy and exchange rate free. Using more appropriate econometric technique in a model aligned to theory, our paper rediscovers the validity of Dornbusch Overshooting hypothesis for Australia, Canada, New Zealand and Sweden more accurately and more robustly than Bjornland's original model.