Monetary Policy Shocks and Exchange Rate Dynamics in Small Open Economies

In this paper we provide new insights on the dynamics between monetary policy shocks and realexchange rates in small open economies using a time-varying structural vector autoregressionmodel with stochastic volatility. Identification is achieved using a combination of short-runand long-run restrictions while preserving the contemporaneous interaction between monetarypolicy and the exchange rate. For several small open economies, we find no evidence of the‘exchange rate puzzle’ or the ‘delayed overshooting puzzle,’ in line with recent studies on thistopic (see e.g. Bjørnland, 2009). However, there is evidence of the ‘forward discount puzzle’ insome countries, suggesting that the uncovered interest parity (UIP) is violated. In addition, asubstantial decrease in the volatility of monetary policy shocks is evident in most countries,accompanied by a decline in the importance of policy shocks in explaining the volatility ofexchange rates and other macroeconomic variables since the 1990s