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Old shocks cast long shadows over the exchange rate

Old shocks cast long shadows over the exchange rate

Title: Old shocks cast long shadows over the exchange rate
Author: Egilsson, Jón   orcid.org/0000-0001-5786-0616
Date: 2019-04-16
Language: English
Scope: 196-218
University/Institute: Háskóli Íslands
University of Iceland
School: Félagsvísindasvið (HÍ)
School of Social Sciences (UI)
Department: Hagfræðideild (HÍ)
Faculty of Economics (UI)
Series: Journal of Applied Economics;22(1)
ISSN: 1514-0326
1667-6726 (eISSN)
DOI: 10.1080/15140326.2019.1597328
Subject: Exchange rate; Interest rate; IRD; Monetary policy; UIP; Gengismál; Vextir; Peningastefna
URI: https://hdl.handle.net/20.500.11815/2099

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Jón Helgi Egilsson (2019) Old shocks cast long shadows over the exchange rate, Journal of Applied Economics, 22:1, 196-218, DOI: 10.1080/15140326.2019.1597328


We propose a new exchange rate model using interest rate differential (IRD) time series as the input, and we fit the new model with empirical data for calibration. We assume that exchange rate modeling cannot be based on the response to a single shock but must instead be based on the response to a series of shocks, as previous shocks could still be playing out and affecting the overall response. We extend the Dornbusch overshooting model and make adjustments to account for empirical findings. The new model is substantiated by empirical data from several currency areas and can explain the so-called exchange rate “puzzles”. Based on the model, we derive a relationship that explains when no IRD will suffice to support a stable exchange rate, which also suggests when policy-makers could be tempted to widen the IRD continually.


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This is an Open Access article distributed under the terms of the Creative Commons Attribution-NonCommercial License (http://creativecom mons.org/licenses/by-nc/4.0/), which permits unrestricted non-commercial use, distribution, and reproduction in any medium, provided the original work is properly cited.

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