The determination of the US dollar/UK pound sterling exchange rate is studied in a small symmetric macroeconometric model including UK–US differentials in inflation, output gap, and short‐ and long‐term interest rates for the four decades since the breakdown of Bretton Woods. The key question addressed is the possible presence of a “delayed overshooting puzzle” in the dynamic reaction of the exchange rate to monetary policy shocks. In contrast to the existing literature, we follow a data‐driven modeling approach combining (i) a vector autoregression (VAR)‐based cointegration analysis with (ii) a graph‐theoretic search for instantaneous causal relations and (iii) an automatic general‐to‐specific approach for the selection of a congruent parsimonious structural vector equilibrium correction model. We find that the long‐run properties of the system are characterized by four cointegration relations and one stochastic trend, which is identified as the long‐term interest rate differential and that appears to be driven by long‐term inflation expectations as in the Fisher hypothesis. It cointegrates with the inflation differential to a stationary “real” long‐term rate differential and also drives the exchange rate. The short‐run dynamics are characterized by a direct link from the short‐term to the long‐term interest rate differential. Jumps in the exchange rate after short‐term interest rate variations are only significant at 10%. Overall, we find strong evidence for delayed overshooting and violations of uncovered interest rate parity (UIP) in response to monetary policy shocks.
We put forward the novel concept of energy contagion, i.e. a deepening of energy-finance linkages under crisis periods in energy markets, and test for this using standard correlation measures and recently proposed adjusted correlation, co-skewness, and co-volatility contagion tests. Our analysis is applied to the oil-exchange rate and oil-stock market relationships of the small petroleum economy of Trinidad and Tobago. By defining our samples for the contagion measures in terms of calm and crisis conditions in the international crude oil market, we are able to compare how various co-moments in the energy-finance nexus change during oil booms and slumps using semi-parametric rule-based algorithms, as well as during relatively tranquil and turbulent oil price volatility episodes with a non-hierarchical k-means clustering algorithm on volatility measures. Our main results show a negative oil-real effective exchange rate dependency; a weak oil-stock returns association; and the existence of several energy contagion channels in both financial relationships, which vanish when we control for the contemporary global financial crash. Energy contagion analysis is essential to financial stability analysis in economies where prosperity is linked to the prices of hard commodities. JEL-Codes: C580, Q490.
We study the exchange rate effects of monetary policy in a balanced macroeconometric two-country model for the US and UK. In contrast to the empirical literature on the 'delayed overshooting puzzle', which consistently treats the domestic and foreign countries unequally in the modelling process, we consider the full model feedback, allowing for a thorough analysis of the system dynamics. The consequential inevitable problem of model dimensionality is tackled in this paper by invoking the approach by Aoki (1981) commonly used in economic theory. Assuming country symmetry in the long-run allows to decouple the two-country macro dynamics of country averages and country differences such that the cointegration analysis can be applied to much smaller systems. Secondly the econometric modelling is general-to-specific, a graph-theoretic approach for the contemporaneous effects combined with an automatic general-to-specific model selection. The resulting parsimonious structural vector equilibrium correction model ensures highly significant impulse responses, revealing a delayed overshooting of the exchange rate in the case of a Bank of England monetary shock but suggests an instantaneous response to a Fed shock. Altogether the response is more pronounced in the former case.
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