Taking Better Aim at Overshooting?

New Economist alerts us to a recent entry in the debate over the Dornbusch overshooting hypothesis:

New Economist: Dornbusch's overshooting hypothesis revisited: ...Rudiger Dornbusch’s (1976) well known exchange rate overshooting states that the nominal exchange rate immediately appreciates with the increase in nominal interest rates, in line with uncovered interest parity (UIP). The problem is, many recent studies suggest otherwise. As Hilde C. Bjørnland of the University of Oslo writes:

Instead they have found that following a contractionary monetary policy shock, the real exchange rate either depreciates, or, if it appreciates, it does so for a prolonged period of up to three years, thereby giving a hump-shaped response that violates UIP. These results have been so persuasive that the puzzles themselves are now about to be considered consensus, of which many recently developed DSGE models seek to replicate.

In Norges Bank working paper 2005/11, Monetary policy and the illusionary exchange rate puzzle, she argues there is a major problem with ...[the] models used. They ignore the immediate effects of a monetary shock on the exchange rate... [T]he Dornbusch hypothesis can be reconciled with the empirical data if one "...leaves the contemporaneous relationship between the interest rate and the exchange rate unaltered". ...

Allowing for full simultaneity between monetary policy and the exchange rate, I find striking results; Contrary to the recent “consensus”, a contractionary monetary policy shock has a strong effect ... consistent with the Dornbusch overshooting hypothesis. Furthermore, the ensuing movement of the exchange rate is with few exceptions consistent with UIP. Hence, I have found no evidence of the typical hump-shaped response found in the empirical literature...