Monetary Policy Shocks and Exchange Rate Dynamics in Small Open Economies

ABSTRACT This paper investigates whether the effects of monetary policy shocks on real exchange rates have changed over time and, if so, whether these changes stem from shifts in transmission mechanisms or from variation in the volatility of the shocks themselves. Using a time‐varying parameter VAR with stochastic volatility for six small open economies, we first show that a constant‐parameter VAR with stochastic volatility provides the best fit to the data in all six cases. We then employ an identification strategy that combines short‐ and long‐run restrictions to isolate monetary policy shocks, and we evaluate its robustness using high‐frequency monetary policy surprises as external instruments. Our results support Dornbusch's overshooting hypothesis in most countries. However, uncovered interest parity is frequently violated, as foreign excess returns diverge from zero following monetary policy shocks. Finally, we document a substantial decline in the volatility of monetary policy shocks since the 1990s, leading to a reduced contribution to exchange rate and macroeconomic fluctuations.