EXCHANGE RATE OVERSHOOTING: HIGH-FREQUENCY IDENTIFICATION AND INSIGHTS INTO MODELS VALIDITY

How fast does the real exchange rate react to monetary policy? According to Dornbusch (1976), a monetary expansion is associated with an immediate appreciation followed by a persistent and gradual depreciation. This phenomenon is known as overshooting. Nonetheless, the empirical literature has been offering mixed and puzzling results. Thus, we have a timing puzzle. Following the identification procedure proposed by Gertler and Karadi (2015), I combine a proxy-SVAR with high-frequency identification (HFI) instruments to assess the role of true monetary shocks. The literature often relies on surprises in Federal funds futures around policy announcements. However, standard HFI proxies might yet fail to disentangle the true monetary shock from the endogenous response of the central bank to information. All in all, using ”cleaned” HFI proxies, monetary shocks cause an immediate overshooting of the real exchange rate. Additionally, I find that not accounting for information shocks leads to incorrect identification and delayed overshooting. Disentangling the two shocks is therefore crucial. Finally, I show that even micro-founded models with information frictions and imperfect rationality can reproduce immediate overshooting.