The effect of monetary policy actions on exchange rates under interest-rate targeting

One puzzling feature of recent empirical studies of the effects of monetary policy changes on exchange rates is the result that the exchange rate does not adjust immediately to the policy shock. Instead, these studies find that it can take as long as two years for the exchange rate to fully reflect the policy change. In this paper, a model of the exchange-rate response to U.S. monetary policy actions which captures these results is specified. This model is also capable of generating standard overshooting results. The authors show that the response pattern of spot and expected future exchange rates depends on the predictability of Federal Reserve actions, the persistence of shocks to the economy, and the reaction of foreign central banks to the U.S. monetary policy shock.