The Role of Money Supply Shocks in Determining Real Exchange Rates: The Evidence

Abstract

This chapter extends the previous one by adding money supply shocks to the set of previously established real shocks affecting real exchange rates to determine whether these monetary factors have also had significant effects. Given the propensity for overshooting, one would expect positive unanticipated domestic money supply shocks to have negative effects on real exchange rates as home residents re-balance their portfolios by buying assets abroad. In addition, it is necessary to determine whether such positive exogenous unanticipated monetary shocks have had downward effects on domestic relative to U.S. interest rates as is widely claimed in the financial press. Monetary shocks that are fully anticipated should affect the domestic inflation rate relative to that in the United States in the same direction and these effects should appear in the interest rate differential as soon as the expectations are formed. The nominal exchange rate and price levels, but not the real exchange rate, will change through time as a result of correctly anticipated monetary shocks.