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We specify a theoretical model of the exchange-rate response to U.S. monetary policy actions that is capable of explaining a wide range of recent empirical results. We show that the response pattern of spot and expected future exchange rates depends on the predictability of Federal Reserve actions, the persistence of shocks to the economy, and the reaction of foreign central banks to the US monetary policy shock. We also show that the movements of spot and expected future exchange rates in anticipation of a monetary policy change can outweigh the immediate responses at the time of the change

Recent empirical studies find that a tightening of US monetary policy is associated with an appreciation of the dollar, while a loosening is associated with dollar depreciation. Using a VAR methodology, Eichenbaum and Evans (1995) find that contractionary shocks to monthly values of the federal funds rate, the ratio of nonborrowed reserves to total reserves, and the Romer and Romer (1989) index over the 1974 to 1990 period led to a sharp increase in the differential between US and foreign interest rates and to a sharp appreciation in the dollar. Clarida and Gali (1994), Evans (1994) and Lewis (1995) also find that contractionary US monetary policy is associated with a dollar appreciation using similar methods. Bonser-Neal et al. (1998), using changes in the Federal Reserve's federal funds rate target as an alternative measure of monetary policy shocks, confirm these results. Specifically, they find that increases in the Federal Reserve's federal funds rate target during the 1974–79 and 1987–94 periods of interest-rate targeting are associated with significant increases in the value of the dollar. While all of these studies estimate a dollar appreciation in response to contractionary monetary-policy shocks, they report different dynamic-response patterns. Bonser-Neal et al. (1998), for example, estimate spot and forward rate responses consistent with standard overshooting models in a majority of the cases they examine. In contrast, Clarida and Gali (1994), Eichenbaum and Evans (1995), and Evans (1994) estimate that it can take from one to three years for the maximal effect of the policy shock to be felt on exchange rates. Bonser-Neal et al. (1998) also estimate that the impact of a policy shock is expected to increase over time in the case of the yen/dollar exchange rate over the 1974–79 period. These latter results are clearly inconsistent with standard overshooting models. In overshooting models, contractionary US monetary policy causes the dollar spot rate to temporarily appreciate beyond, or overshoot, its new higher equilibrium level. Future exchange rates are therefore expected to appreciate by less than the current spot rate in response to a tightening of monetary policy. Taken together, these empirical results suggest that the standard overshooting model may be too restrictive to completely characterize the effects of monetary policy on exchange rates. We present a theoretical model based on rational expectations and uncovered interest parity that is capable of explaining most of the recent empirical results concerning the effects of US monetary policy shocks on exchange rates. In all versions of the model, we assume that the US economy is subjected to economic shocks that may be persistent and that the Federal Reserve may choose to offset these shocks by changing its federal funds rate target. We also assume that foreign central banks alter their policies in response to either the common global economic shock or to the Federal Reserve action itself. This assumption is consistent with recent empirical evidence that foreign interest rates respond to US economic news and short-term interest rates. Finally, we assume that the expectations hypothesis of the term structure holds for both US and foreign interest rates, and that these interest rates are linked to exchange rates by uncovered interest parity. Together, these assumptions allow us to derive the dynamic response of exchange rates to changes in the federal funds rate target. Under certain assumptions, our model replicates the standard overshooting results. In particular, an unanticipated increase in the federal funds rate target leads to an immediate and persistent increase in the differential between US and foreign interest rates, and to an immediate appreciation of the dollar. The policy shock causes the spot rate to overshoot its new equilibrium level, however, so that the magnitude of the dollar's expected appreciation decreases with the time horizon. We also find that the magnitude of the spot exchange rate response depends on both the predictability of policy changes and the extent to which foreign central banks follow the Federal Reserve's action. The general specification of our model, which includes overshooting as a special case, implies a wide range of possible spot and expected future exchange rate responses to US monetary policy shocks. In particular, for some parameter values, an unanticipated increase in the federal funds rate target causes a rise in the differential between US and foreign interest rates and an appreciation of the dollar as before, but with the dollar continuing to appreciate in future periods. That is, our model is capable of generating the non-overshooting results of some of the studies cited above. Other parameter values lead to a range of additional results that also are not consistent with the standard overshooting model. We show, for example, that unanticipated increases in the federal funds rate target can cause a depreciation of the dollar. We also demonstrate that a decrease in the US-foreign interest rate differential can be consistent with an appreciation of the dollar. In other words, neither the direction of the US interest rate change nor the direction of the change in the US-foreign interest rate differential is sufficient to determine the sign of exchange rate movements. Finally, our model extends recent studies of the effects of monetary policy on exchange rates by modeling the effects of anticipated changes in the federal funds rate target by the Federal Reserve, in addition to the effects of unanticipated target changes. “Peso problem” episodes already demonstrate that the possibility of an extreme policy event can significantly affect exchange rates. In our case, however, we examine how typical monetary-policy actions can be reflected in exchange rates before they are implemented.1 We find that the effects of anticipated changes in the target rate can be greater than the effects from target-change shocks. Moreover, we find that it is possible for the value of the expected future exchange rate to rise in anticipation of a policy action, and then decline once the policy-action is made. Following this introductory section, we present an open-economy version of a standard sticky-price model of the US economy in the second section. We also specify domestic and foreign central bank reaction functions. We derive the responses of interest rates and exchange rates to federal funds rate target changes in the third section. In the fourth section, we consider a set of numerical examples to explore the range of possible outcomes for the exchange rate response to federal funds rate target changes. We examine these responses both in a standard overshooting model and in a general model that includes overshooting as a special case. In the fifth section, we summarize the main conclusions of the paper

In this article, we specified models of the exchange-rate response to US monetary policy actions. The models emphasize the role of the Federal Reserve's reaction function in determining the response, as well as the extent to which policy actions are anticipated. Despite the fact that we assume both rational expectations and uncovered interest parity, we find that the spot and expected future exchange rates can exhibit a number of different response patterns in addition to the standard overshooting result. These different outcomes depend not only on the predictability of Federal Reserve actions, but also on the reaction of foreign central banks to US monetary policy changes. Our models are capable of explaining both the overshooting and nonovershooting results of recent empirical research. In the latter case, we show that the dollar can appreciate in value for a number of future periods in response to a contractionary US policy action, with the greatest value therefore occurring in some future period. This result is consistent with a strong short-run reaction by foreign central banks to either a common global shock or the US monetary policy action. We also demonstrate that this exchange-rate response pattern is more likely as the predictability of Federal Reserve policy actions declines. In addition to the response patterns reported in recent empirical research, we find that a wide variety of other exchange-rate response patterns are possible. In particular, we show that an increase in the federal funds rate target can cause an expected future depreciation of the dollar. We additionally find that a decrease in the US-foreign interest-rate differential can lead to expected future appreciation of the dollar. Consequently, neither the direction of the US interest-rate change nor the direction of the change in the interest-rate differential is sufficient to determine the exchange-rate response pattern. We also show that the responses of spot and future expected exchange rates in anticipation of a policy action can be larger than the responses to the policy action itself. Moreover, we find that the spot and expected future values of the dollar can appreciate in anticipation of a Federal Reserve tightening, but then depreciate once the action is taken. Specific parameter values for the behavior of foreign central banks, the predictability of Federal Reserve policy, and the persistence of economic shocks are needed to determine the precise behavior of exchange rates both in anticipation of and in response to Federal Reserve policy actions. Finally, our results generally support the claims of others who note that the behavior of foreign central banks and foreign interest rates is an important component in considering the effects of US monetary policy on exchange rates. Lewis (1995), for example, notes that focusing on US monetary variables alone is a shortcoming, and she includes foreign interest rates in her VAR analysis in an attempt to control for foreign monetary policy. Eichenbaum and Evans (1995) consider the effects of foreign interest rates separately in their VAR models for similar reasons. Becker et al. (1995) also conclude that the assumption of predetermined foreign interest rates is inappropriate when considering the effects of US economic shocks. The theoretical results from our models demonstrate that the responses of foreign central banks to US monetary policy changes can have potentially large effects on the dynamic behavior of exchange rates.