Exchange Rates and Uncovered Interest Differentials: The Role of Permanent Monetary Shocks

This paper estimates an empirical model of exchange rates and uncovered interest rate differentials with permanent U.S. monetary policy shocks. Using post-Bretton-Woods data from the United States, the United Kingdom, Japan, and Canada, it reports two main findings: First, monetary shocks that increase the U.S. nominal interest rate and inflation in the long run depreciate the dollar in nominal and real terms in the short run. Second, permanent increases in the U.S. interest rate cause short-run deviations from uncovered interest-rate parity against U.S. assets. The signs of these effects are opposite to those reported in the related literature for transitory monetary policy shocks. The estimated responses to transitory and permanent monetary shocks are shown to be qualitatively consistent with the predictions of a new Keynesian model of the open economy with portfolio adjustment costs.