The Effect of Monetary Shocks on Exchange Rate

This paper uses econometric techniques to analyze the effect of monetary shocks on domestic exchange rate. The basic estimation method used to analyze the various shocks is vector autoregression (VAR). Vector autoregression has the unique ability to shed light on causality between variables in ways that other methods tend to lack. This ability is partially due to VAR's lack of assumptions regarding causality prior to the performance of the actual estimates. This paper specifically investigates causality between monetary shocks and exchange rate through two different statistical calculations derived from the various vector autoregressions, impulse response functions and decomposition analysis. Data used in the econometric estimations come from ten countries. Three of the countries are considered economically developed. The remaining seven are generally classified as emerging economies. The unexpected result of the estimations is that the effect of domestic monetary shocks and foreign monetary shocks vary widely and are quite different for each of the ten countries. There appears to be no single rule that predicts the outcome for most countries.