Liquidity and Exchange Rates: Puzzling Evidence from the G-7 Countries

This paper considers the empirical evidence on in open economies; we study the of monetary policy shocks (identified by innovations in interest rates) on rates. Both overshooting models with short-run price stickiness and flexible-price models with liquidity effects suggest that, in the short-run, the of a positive monetary innovation will be a reduction of nominal interest rates and a depreciation of the domestic currency. We consider VAR systems for the G-7 countries and find that, while positive innovations in U.S. interest rates lead to an impact appreciation of the U.S. dollar, positive innovations in the interest rates of the other G-7 countries are associated with an impact depreciation of their currency. We offer two explanations of this exchange rate puzzle; one is based on the idea that the U.S. is the leader country in the setting of monetary policy for the G-7 area, while the other countries are follow! ers. The other explanation suggests endogenous policy reaction to underlying inflationary shocks that are a cause of rate depreciation. We then offer some empirical evidence consistent with these two interpretations of the rate puzzle: after controlling for U.S. monetary policies and expected inflation, the response of rates to postive interest rate shocks is a persistent currency appreciation in most of the G-7 countries. Moreover, consistently with both overshooting and models, a monetary contraction is associated with a transitory appreciation of the real rate and a temporary fall in output.