Journal of Monetary Economics 45 (2000) 561}586

Exchange rate anomalies in the industrial

countries: A solution with a structural
VAR approach
Soyoung Kim *, Nouriel Roubini

Department of Economics, University of Illinois at Urbana-Champaign, 1407 W. Gregory Drive,
Urbana, IL 61801, USA

Stern School of Business, New York University, New York, NY 10012, USA
National Bureau of Economic Research, Cambridge, MA 02138, USA
Center for Economic Policy Research, London, EC1V 7RR, UK
White House Council of Economic Advisers, Washington, DC 20502, USA
Received 28 October 1998; received in revised form 27 April 1999; accepted 28 June 1999

Abstract
Past empirical research on the e!ects of monetary policy in closed and open economies
found evidence of several anomalies, such as the &liquidity', &price', &exchange rate' and
&forward discount bias' puzzles. In this paper, we develop an approach that provides
a solution to these empirical anomalies in an open economy setup. We use a &structural
VAR' approach with non-recursive contemporaneous restrictions and we identify monetary policy shocks by modeling the reaction function of the monetary authorities and the
structure of the economy. Our empirical "ndings are that e!ects of non-US G-7 monetary policy shocks on exchange rates and other macroeconomic variables are consistent
with the predictions of a broad set of theoretical models. The evidence is consistent with
signi"cant, but transitory, real e!ects of monetary shocks. The &price' puzzle is addressed
and there is little evidence of open economy anomalies. Speci"cally, initially the exchange

We thank an anonymous referee and Christopher Sims for helpful discussions and suggestions,
and participants at the CEPR Workshop on Monetary Transmission, and seminars at MIT, New
York University, the Bank of Israel, the Board of Governors of the Federal System, and the New
York Federal Reserve Bank for useful comments. The usual disclaimer applies.

* Corresponding author. Tel.: 001-217-265-0682; fax: 001-217-333-1398.

E-mail address: kim11@uiuc.edu (S. Kim)
0304-3932/00/$ - see front matter  2000 Elsevier Science B.V. All rights reserved.
PII: S 0 3 0 4 - 3 9 3 2 ( 0 0 ) 0 0 0 1 0 - 6

562

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

rate appreciates in response to a monetary contraction; but after a few months, the
exchange rate depreciates over time in accordance with the uncovered interest parity
condition. Overall, our identi"cation scheme gives results that contribute to resolve the
empirical anomalies about the e!ects of monetary policy shocks found in the literature.  2000 Elsevier Science B.V. All rights reserved.
JEL classixcation: C32; E52; F31; F42
Keywords: Monetary policy shocks; Exchange rates; G-7 countries; Structural VAR

1. Introduction
This paper presents an empirical analysis for the major industrial countries of
the e!ects of monetary policy on the exchange rate. The vast empirical literature on the e!ects of monetary policy in closed and open economies has been
plagued by a number of puzzles. Such puzzles can be summarized as follows:
1. The liquidity puzzle. When monetary policy shocks are identi"ed as innovations in monetary aggregates (such as M0, M1 and M2), such innovations
appear to be associated with increases rather than decreases in nominal interest
rates (see Reichenstein, 1987; Leeper and Gordon, 1991).
2. The price puzzle. When monetary policy shocks are identi"ed with innovations in interest rates, the responses of output and money supply are correct as
a monetary tightening (an increase in interest rates) is associated with a fall in
the money supply and output. However, the response of the price level is wrong
as monetary tightening is associated with an increase in the price level rather
than a decrease (see Sims, 1992).
3. The exchange rate puzzle. While a positive innovation in interest rates in the
United States is associated with an impact appreciation of the U.S. dollar
relative to the other G-7 currencies (as found by Eichenbaum and Evans, 1995),
such monetary contraction in the other G-7 countries is often associated with an
impact depreciation of their currency value relative to the U.S. dollar (see Grilli
and Roubini, 1995; Sims, 1992).
4. The forward discount bias puzzle. If uncovered interest parity holds, a positive innovation in domestic interest rates relative to foreign ones should lead to
a persistent depreciation of the domestic currency over time after the impact
appreciation, as the positive interest rate di!erential implies an expected depreciation of the currency. However, the evidence suggests that positive interest
di!erentials on domestic assets are associated with persistent appreciations of

 Recent studies on this issue using VAR methodologies include Eichenbaum and Evans (1995),
Clarida and Gertler (1997), Cushman and Zha (1997), Grilli and Roubini (1995), and Sims (1992).

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

563

the domestic currency (for periods up to two years after the initial monetary
policy shock).
Empirical and methodological work in closed economies has addressed the
"rst two puzzles and provided suggestions on how to explain them. For what
concerns the liquidity puzzle, Sims (1992) suggested that innovations in monetary aggregates may not correctly represent changes in monetary policy in the
presence of money demand shocks. Thus, he proposed considering innovations
in short-term interest rates as indicators of a change in monetary policy.
However, such a solution is not fully satisfactory as it leads to the &price puzzle':
a monetary contraction is associated with a persistent increase in the price level.
Other authors (Strongin, 1995; Christiano and Eichenbaum, 1992a; Eichenbaum, 1992; Eichenbaum and Evans, 1995) suggested identifying monetary
policy shocks with narrow monetary aggregates (such as non-borrowed reserves) that may be better proxies of monetary policy.
Sims (1992) suggested that the price puzzle might be due to the fact that
interest rate innovations partly re#ect in#ationary pressures that lead to price
increases. He also argued, and Grilli and Roubini (1995) provided evidence, that
this explanation of the price puzzle might also explain the exchange rate puzzle.
To address this explanation of the price puzzle, Sims and Zha (1995) propose
&structural VAR' approach with contemporaneous restrictions that includes
variables proxying for expected in#ation. Their methodology is appealing for
several reasons: it allows distinguishing between money supply and money
demand shocks, something necessary to address the liquidity puzzle; it allows
modeling structural contemporaneous restrictions across di!erent equations
rather than a recursive structure; the use of price data that capture in#ationary
expectations is helpful to solve the price puzzle. Finally, the results are consistent
with the expected e!ects of a monetary contraction: this policy change is
associated with an increase in interest rates, a reduction in the money supply,
a transitory fall in output (or no real e!ects) and a persistent reduction in the
price level. This closed economy identi"cation scheme is also supported by the
work of Kim (1999) on the other G-7 countries.
 The forward discount puzzle is related to the "nding of a &delayed overshooting' of exchange
rates in VAR responses to interest rate shocks; in a unrestricted VAR framework, see Eichenbaum
and Evans (1995) for the U.S. dollar exchange rate and Grilli and Roubini (1995) for the other G-7
countries. The result is consistent with the evidence that the forward exchange rate is a biased
predictor of the future spot rate (see Froot and Thaler, 1990).
 Christiano et al. (1996) and Gordon and Leeper (1994) solve the price puzzle in a recursive
system by adding in#ationary expectation proxies. However, this identi"cation scheme cannot be
applied to non-U.S. G-7 countries, as they do not use non-borrowed reserves as a monetary policy
tool. Also, an earlier version of Kim (1999) shows that innovations in narrow monetary aggregates
(total reserves or M0) produce &liquidity' and &price' puzzles in the non-U.S. G-5 countries even after
including world commodity prices. Gordon and Leeper (1994)'s "nding is restricted to the 1980s in
the U.S.; this scheme is also subject to drawbacks, discussed in Sims and Zha (1995).

564

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

In this paper we extend the structural VAR approach of Sims and Zha, 1995
to an open economy and show that it can be used to explain the e!ects of
monetary policy on exchange rates. Previous work, using an &unrestricted VAR'
approach, provided evidence of an exchange rate puzzle (Grilli and Roubini,
1995) and a &delayed overshooting' (Eichenbaum and Evans, 1995; Grilli and
Roubini, 1995). While the unrestricted VAR approach with measures of expected in#ation resolves the exchange rate puzzle for most countries (see Grilli
and Roubini, 1995), there are several limitations to it. First, to identify structural
shocks such as monetary policy ones, it is useful to use a non-recursive approach. For example, to obtain an impact e!ect of interest rate innovations on
the exchange rate, one has to put the latter after the domestic interest rate in the
VAR ordering; this implies that monetary policy cannot contemporaneously
respond to exchange rate shocks. This is not appealing for two reasons. One,
small open economies who are concerned about the e!ects of exchange rate
depreciation on their in#ation rate might react quite rapidly to exchange rate
shocks with interest rate tightening. Two, the interpretation suggested in Grilli
and Roubini (1995) and Sims (1992) implies that the depreciation in periods
when interest rate is increasing can be explained as monetary policy being
tightened when these depreciations are observed. Therefore, it is useful to use an
identi"cation scheme that allows for a contemporaneous response of monetary
policy to exchange rate shocks. Second, the solution of the price puzzle was only
partial in the unrestricted VAR approach used by Grilli and Roubini (1995).
Third, the identi"cation proposed by Eichenbaum and Evans (1995) and Grilli
and Roubini (1995) leads to a &delayed overshooting' e!ect even when the impact
response of the exchange rate is correct: positive di!erentials between domestic
and foreign interest rates are associated with long and persistent periods of
domestic currency appreciation in spite of the depreciation predicted by the
uncovered interest parity condition. While this result may not be overturned by
di!erent econometric methodologies (as suggested by Grilli and Roubini, 1995)
and might instead be explained by models of learning (such as that of Gourinchas and Tornell, 1995), it is worth exploring whether a di!erent structural
identi"cation leads to the same puzzling result.
To anticipate the results in the paper, our identi"cation scheme appears to be
successful in identifying monetary policy shocks and solving the empirical
puzzles about the e!ects of monetary policy shocks in the non-US G7 countries. The liquidity puzzle is resolved; the price level falls following a contractionary monetary policy while output has a transitory contraction. Moreover,
the impact response of the exchange rate to a monetary contraction is an
appreciation and there is less evidence of a forward discount bias puzzle and
delayed overshooting.
 See the working paper version of this paper, Kim and Roubini (1997) for the U.S. results, based
on the similar identifying scheme.

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

565

The structure of this paper is as follows. In Section 2, we summarize the

structural VAR modeling method and present the details of our identi"cation
scheme for monetary policy shocks. In Section 3, we investigate whether the
predictions of the identi"cation scheme are appropriate by looking at whether
the response of major domestic macro variables and the exchange rate to the
identi"ed monetary policy shocks match those predicted by theory. In Section 4,
we present some suggestions for further research.

2. Identi5cation scheme
2.1. Structural VAR modeling
We assume the economy is described by a structural form equation
G()y "e ,
R
R

(1)

where G() is a matrix polynomial in the lag operator , y is an n;1 data

R
vector, and e is an n;1 structural disturbances vector. e is serially uncorrelated
R
R
and var(e )"K and K is a diagonal matrix where diagonal elements are the
R
variances of structural disturbances; therefore, structural disturbances are assumed to be mutually uncorrelated.
We can estimate a reduced form equation (VAR)
y "B()y #u ,
R
R
R

(2)

where B() is a matrix polynomial (without the constant term) in lag operator
and var(u )"R.
R
There are several ways of recovering the parameters in the structural form
equations from the estimated parameters in the reduced form equation. Some
methods give restrictions on only contemporaneous structural parameters.
A popular and convenient method is to orthogonalize reduced form disturbances by Cholesky decomposition (as in Sims (1980) among others). However,
in this approach to identi"cation, we can assume only a recursive structure, that
is, a Wold-causal chain. Blanchard and Watson (1986), Bernanke (1986), and
Sims (1986) suggest a generalized method (structural VAR) in which nonrecursive structures are allowed while still giving restrictions only on contemporaneous structural parameters.
Let G be the coe$cient matrix (non-singular) on  in G(), that is, the

contemporaneous coe$cient matrix in the structural form, and let G() be the
coe$cient matrix in G() without contemporaneous coe$cient G . That is,

G()"G #G().


(3)

566

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

Then, the parameters in the structural form equation and those in the reduced
form equation are related by
B()"!G\G().


(4)

In addition, the structural disturbances and the reduced form residuals are
related by e "G u , which implies
R
 R
R"G\KG\Y.



(5)

Maximum likelihood estimates of K and G can be obtained only through


sample estimates of R. The right-hand side of Eq. (5) has n;(n#1) free
parameters to be estimated. Since R contains n;(n#1)/2 parameters, we need
at least n;(n#1)/2 restrictions. By normalizing n diagonal elements of G to

1's, we need at least n;(n!1)/2 restrictions on G to achieve identi"cation. In

the VAR modeling with Cholesky decomposition, G is assumed to be triangu
lar. However, in the structural VAR approach G can be any structure as long as

it has enough restrictions.
2.2. Identifying monetary policy shocks
In our model, the data vector is +R, M, CPI, IP, OPW, FFR, E(/$),, where
R is a short-term interest rate, M is a monetary aggregate (M0 or M1), CPI is
the consumer price index, IP is industrial production, OPW is the world price of
oil in terms of the U.S. dollar, FFR is the Federal Funds Rate of the U.S., and
E(/$) is the exchange rate expressed as units of foreign currency for one unit of
U.S. dollars.
The "rst four variables are well-known variables in monetary business cycle
literature. The next two variables, the world price of oil and the U.S. Federal
Funds Rate, are included to isolate &exogenous' monetary policy changes. Since
the monetary authority follows a feedback rule by reacting to news in the
economy in setting its monetary policy, it is important to control for the
systematic component of the policy rule in order to identify &exogenous' monetary policy changes. If the monetary authority tightens monetary policy in
response to a negative and in#ationary supply shock, the ensuing recession and
price in#ation is not only due to the monetary contraction but also due to the
original negative supply shocks. To identify the part due to monetary policy
alone, we include the world price of oil as a proxy for negative and in#ationary

 We used M1 for German, Italian, and French models, and M0 for Japanese, U.K., and Canadian
models. We examine the robustness of our results to the use of alternative money aggregates
including also M2.

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

567

supply shocks. The sixth variable, the U.S. Federal Funds rate, is introduced to
control for the component of domestic monetary policy that is a reaction to
foreign monetary policy shocks: Grilli and Roubini (1995) show that it is
important to control for U.S. monetary policy in empirical models of small open
economy of the other G-7 countries. Finally, the nominal exchange rate is
introduced to consider the e!ects of our identi"ed monetary shocks on the value
of the domestic currency.
For the restrictions on the contemporaneous structural parameters G , we

follow the general idea of Sims and Zha (1995) but modify it substantially in
a number of respects. The following equations summarize our identi"cation
scheme based on Eq. (5), e "G u .
R
 R
e

+1

e
g
+"

e
0
!.'
e
" 0
'.
e
0
-.5
e
0
$$0
e $
g

# 

g

1


1

g

g

1

g




g


g

0

0
0

g

0

g

g

1

g

g


g


u
0
u
+
u
!.'
u
,
'.
u
-.5
u
$$0
u $
# 

(6)

where e , e , e , e , e
,e ,e
are the structural disturbances, that
+1 +" !.' '. -.5 $$0 #$
is, money supply shocks, money demand shocks, CPI shocks, IP shocks, OPW
shocks, FFR shocks, and E(/$) shocks, respectively, and u , u , u , u , u
,
0 + !.' '. -.5
u , and u $ are the residuals in the reduced form equations, which
$$0
# 
represent unexpected movements (given information in the system) of each
variable.
Before we explain the details of our identifying restrictions, it is worth noting
that the following relations are contemporaneous restrictions on the structural
parameters of G without further restrictions on the lagged structural param
eters. The money supply equation is assumed to be the reaction function of the
monetary authority, which sets the interest rate after observing the current value
of money, the exchange rate and the world price of oil but not the current values
of output, the price level, and the U.S. Federal Funds Rate. As in Sims and Zha
(1995), the choice of this monetary policy feedback rule is based on the assumption of information delays that do not allow the monetary policy to respond
within the period (the month in our data) to price level and output developments. In other terms, data on money, exchange rates and the world price of oil
are available within the period, but those on output and price level are not. In
this respect, our use of monthly data rather than quarterly data as in Sims
and Zha (1995) makes this informational assumption more appropriate since
it is more likely that the monetary authority cannot observe and react to

568

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

aggregate output data and aggregate price data within a month than within
a quarter.
One exception for this information delay assumption is that we exclude the
contemporaneous U.S. Federal Funds Rate in the monetary reaction function
even though it is available within a month. One justi"cation for this assumption
is that, within a month, monetary authority cares more about unexpected
changes in exchange rate against the U.S. rather than the unexpected changes in
U.S. interest rate per se. Or, within a month, the U.S. interest rate does not have
additional information for non-U.S. monetary authorities after they consider
their exchange rate against the U.S. dollar. We include the world price of oil and
the exchange rate in the monetary policy reaction function to control for current
systematic responses of monetary policy to the state of economy like in#ationary shocks. By including the oil price, we control for current systematic responses to (negative) supply shocks and in#ationary pressure. The inclusion of
the exchange rate is particularly appropriate for two reasons. First, the G-7
countries other than the U.S. have been implicitly and explicitly concerned
about the e!ects of a depreciation of their currencies on their in#ation rates.
Second, by controlling for the components of interest rate movements that are
systematic responses to a depreciation of the domestic currency, we are more
likely to identify the interest rate innovations that are true exogenous contractions in monetary policy and that should lead to a currency appreciation.
We assume a usual money demand function. The demand for real money
balances depends on real income and the opportunity cost of holding money
} the nominal interest rate. So, in our money demand equation, we exclude
(contemporaneously) the three other variables, i.e. the world price of oil, the U.S.
interest rate, and the exchange rate. For the other equations, our general
assumption is that real activity responds to price and "nancial signals (interest
rates and exchange rates) only with a lag. The interest rates, money, the U.S.
interest rate, and the exchange rate are assumed not to a!ect the level of real
activity contemporaneously. They are assumed to a!ect real activity with
a one-period lag. While exchange rates will eventually feed through to the
domestic CPI, evidence suggests that this pass-through e!ect is not instantaneous, but it is likely to vary relatively slowly over time (see Goldberg and
Knetter, 1996); however, since oil is a crucial input for most economic sectors,
the price of oil is assumed to a!ect prices and the real sector contemporaneously.
One motivation for this identifying assumption is that "rms do not change their
output and price unexpectedly in response to unexpected changes in "nancial
 Note also that in most countries monetary policy is changed at discrete points in time. For
example, in the U.S. the FOMC meets about eight times a year while o$cial monthly data on the
CPI, industrial production and employment are announced with a one month lag; GDP data are
quarterly and published in the quarter following the relevant one. Financial data instead are
available on a daily basis and monetary aggregate data are available within the month.

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

569

signals or monetary policy within a month due to inertia, adjustment costs and
planning delays, but they do in response to those in oil prices following their
mark-up rule. In summary, we assume a block of equations determining CPI
and IP from which all the other variables are excluded with the exception of the
world price of oil.
The identifying restriction in the equations for the price of oil and for the U.S.
interest rate takes these variables as being contemporaneously exogenous to any
variable in the domestic economy. We include the price of oil in the U.S. interest
rate equation to capture the idea that the U.S. Fed will tighten monetary policy
in response to oil price related in#ationary shocks. Finally, the exchange rate
equation is an arbitrage equation that describes the "nancial market equilibrium. Since the exchange rate is a forward-looking asset price, we assume that all
variables have contemporaneous e!ects on the exchange rate in this equation.
In summary, the structural shocks are composed of several blocks. The "rst
two equations are money supply and money demand equations which describe
money market equilibrium. The next two describe the domestic goods market
equilibrium; the "fth and sixth equations represent the exogenous shocks originating from the world economy, the U.S. interest rate and oil price shocks. The
last is the arbitrage equation describing exchange rate market.
In Table 1, we report the estimated coe$cients. The numbers in the brackets
are standard errors. Data are monthly and the estimation period is 1974:7}
1992:12 (in France, the estimation period was 1974:7}1992:2, and in Canada,
1974:7}1992:5 because of data limitations). All variables were used in logarithm
form except for interest rates. Complete seasonal dummies are used in all
estimations. Six lags were assumed. The estimated values of g , g and
 
 Sims and Zha (1995) present a dynamic stochastic general equilibrium model which is consistent
with these identifying restrictions.
 In some cases, large standard errors are found. However, this seems to be due to high
correlations among variables rather than wrong identifying assumptions. Moreover, the moderate
standard errors for impulse responses suggest that total uncertainty is not as high as what is
represented by individual standard errors.
 We examined the sub-sample stability of the estimated VAR coe$cients and impulse responses.
We compared the model over the whole sample period with the model estimated over various
sub-periods. The former (the original model) is preferred by the Akaike Criterion, the HannanQuinn Criterion, and the Schwartz Criterion except partially for the three cases. The impulse
responses are similar for the di!erent estimation periods in most cases. This suggests that our
estimation over the whole sample period is reasonable (details are available in the working paper
version of the paper, Kim and Roubini, 1997).
 An observation on non-stationarity and co-integration. Our statistical inference is not a!ected
by presence of non-stationarity since we follow a Bayesian inference (see Sims, 1988; Sims and Uhlig,
1991). Some theoretical models predict that some variables may be cointegrated or integrated. If we
strongly believe that such a relation exists, then we have to impose such a restriction; it is however,
not clear whether the variables in the system are indeed co-integrated or integrated. Moreover, if we
impose false restrictions, our inference would be incorrect.

570

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

Table 1
Contemporaneous coe$cients in the structural models
Germany
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.
g

Std.

error
error
error
error
error
error
error
error
error
error
error
error
error
error
error
error

Japan

!1502
!30.70
41099
18.91
!70
!1.39
1899
0.86
!933
!7.98
2569
18.82
0.46
0.10
0.81
0.10
!2.84
0.83
9.95
0.85
!0.79
0.17
1.71
0.21
!0.00049 !0.0064
0.00800
0.0213
!0.0053 !0.0033
0.0016
0.0036
!0.014
!0.0016
0.013
0.0113
!0.62
!0.86
0.69
0.65
!0.0072
0.046
0.0049
0.068
!0.54
!1.06
0.76
2.02
!1.34
!0.39
1.32
0.63
0.13
!0.15
0.15
0.36
!0.025
!0.071
0.031
0.107
!0.010
!0.0059
0.003
0.0035

U.K.

France

Italy

Canada

!126
127
1.35
1.33
!17.22
15.79
0.010
0.012
!0.090
0.140
0.016
0.045
0.012
0.021
!0.0014
0.0042
0.030
0.013
!0.51
0.69
0.013
0.019
!4.50
2.97
1.12
0.62
!0.16
0.20
0.018
0.042
!0.0077
0.0043

*
*
!0.25
0.49
!3.39
4.61
0.00062
0.00140
0.13
0.37
0.030
0.048
!0.014
0.009
!0.0062
0.0017
0.0010
0.0135
!1.08
0.70
0.012
0.018
!0.016
0.220
0.10
1.21
0.093
0.157
!0.0078
0.0311
!0.011
0.003

*
*

!7.55
6.44
0.81
0.72
!47.76
12.45
0.0093
0.0060
0.23
0.37
0.068
0.087
0.026
0.015
0.00057
0.00287
!0.016
0.013
0.055
0.658
0.027
0.008
!0.30
0.17
0.081
0.408
!0.23
0.10
0.020
0.018
!0.013
0.003

5.11
3.39
!62.63
43.49
0.0081
0.0083
0.0088
0.5114
!0.089
0.044
!0.015
0.010
!0.0018
0.0027
!0.014
0.019
!0.42
0.69
0.20
0.21
!5.41
10.24
!13.09
15.94
1.05
1.69
0.21
0.36
!0.021
0.018

g are negative in most cases. This implies that the monetary authority

increases interest rates when it observes unexpected increases in the monetary
aggregates and in the price of oil, and unexpected exchange rate depreciation.
That is, monetary authority takes a contractionary position when faced with

 There are some cases in which the estimated coe$cients have positive signs } g in the U.K.,

Canada and Italy. However, the U.K. and Canada are oil exporting countries, so the positive sign of
the estimated coe$cients does not seem to be problematic as a positive oil shock does not
necessarily lead to a large in#ationary outcome.

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

571

Table 2
Likelihood test of over-identifying restrictions

Germany
Japan
U.K.
France
Italy
Canada

Chi-square

Signi"cance level

s(5)"0.718
s(5)"5.296
s(5)"3.832
s(6)"4.129
s(6)"16.667
s(5)"7.046

0.982
0.381
0.574
0.659
0.011
0.217

in#ationary pressures. In Table 2, we report the likelihood ratio test of the

over-identifying restrictions. Except for the Italian model, our identifying restrictions are not rejected at any conventional signi"cance level.

3. The e4ects of monetary policy shocks

3.1. General description of the likely ewects of a monetary contraction
Before we report the empirical results from our model, we discuss what are the
expected movements of the macro variables including exchange rates given
available theories about the e!ects of a monetary contraction. Some of them,
such as the absence of a price or liquidity puzzle serve as quite strict criteria for
judging the validity of our empirical models since it may be di$cult to say that
our identi"ed monetary policy shocks are close to true monetary policy shocks if
such puzzles persist. In a monetary contraction, interest rates rise initially and
monetary aggregates fall initially. These are general indications of tighter monetary policy stance. An initial rise in interest rates may be reversed in the very
short run due to de#ationary pressure from a monetary contraction; however,
the initial impact must be an interest rate rise and a money supply fall. Second,
the price level declines and the output level does not increase. We may observe
an output increase or a price level increase after a monetary contraction, but if
the monetary contraction is really &exogenous' in the sense that it is not

 For France and Italy, we give another zero restriction on g . This restriction delivers

economically more reasonable impulse responses compared to those obtained using our base
identi"cation scheme. There are two justi"cations for this assumption. First, in some countries
where monetary aggregate targeting has been uncommon, the monetary authority may not systematically care about the current monetary aggregates in setting the interest rate. Second, in some
countries, information on broad monetary aggregates, such as M1, may not be available within
a month.

572

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

a systematic response to any shock (for example, oil shocks, in#ationary pressure, money demand shocks, or foreign policy shocks) then almost no theory
implies that the output or price level should increase. We may set up a stronger
position for the price level response, since almost all theoretical models predict
a price level fall. In contrast, for the output response some models predict no
real e!ect, even in the short-run, of monetary policy; therefore, the empirical
results will provide evidence on whether money is non-neutral in the short-run
and the magnitude of such potential real e!ects.
What about the e!ects of a monetary contraction on the exchange rate? The
e!ect of interest rate increases on the exchange rate depends on the disturbance
that leads to the change in interest rates. A contractionary monetary policy that
increases the domestic interest rate for a given expected in#ation rate will lead to
an impact nominal appreciation of the exchange rate. However, not all increases
in interest rates will be associated with a currency appreciation: if there is an
increase in expected in#ation, the ensuing Fisherian increase in the nominal
interest rate would be associated with an impact depreciation of the exchange
rate. Therefore, the impact response of the exchange rate to an increase in the
interest rate will depend on whether it is the nominal or the real interest rate that
is increasing. Note that, as long as we are able to control for the components
of interest rate changes that are due to a change in expected in#ation, both
overshooting models with short-run price stickiness (such as Dornbusch, 1976)
and #exible price models with liquidity e!ects (such as Grilli and Roubini,
1991,1992,1993; Schlagenhauf and Wrase, 1995) suggest that the e!ects of
a positive monetary innovation will be a reduction of nominal interest rates and
an impact depreciation of the domestic currency.
3.2. Empirical results
In Figs. 1 and 2, we display the estimated impulse responses in each country
(France, U.K. and Italy in Fig. 1, Canada, Germany and Japan in Fig. 2) to
a domestic contractionary monetary shock. We discuss "rst the e!ects of this
policy shock on the domestic variables and consider next the e!ects of these
 Formally, one can derive theoretical models where a monetary contraction leads to a price
increase as in Beaudry and Devereux (1995); however, most models suggest that the opposite case
would be the likely one.
 Note that an output fall is implied not only by Keynesian models with price-wage inertia, but
also by &liquidity models' with #exible prices and wages (see Christiano and Eichenbaum, 1992b;
Chari et al., 1995 in a closed economy and Grilli and Roubini, 1991, 1992, 1993 in an open economy
setup). A short-run output fall is also obtained in dynamic stochastic general equilibrium models
with a nominal rigidity.
 While the impact e!ect of a monetary shock on the exchange rate is qualitatively independent
of whether we consider "xed-price models or #exible-price models with monetary neutrality, the
dynamic e!ects over time will depend on the speci"c theoretical model considered in the analysis.

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

573

Fig. 1. Impulse responses to monetary policy shocks.

monetary contractions on the exchange rate. Each column of the "gure gives the
impulse responses (over 48 months) to a one-standard-deviation positive interest rate shock (i.e. a monetary contraction). The responding variables are
named at the far left of each row. The upper and lower dashed lines plotted in
each graph are one-standard-error bands. The response graphs in a given row
all have the same scale, with the maximum and minimum heights shown on any
graph in the row noted to the left of the graph. In response to a money supply
shock, initially the interest rate signi"cantly rises and the money supply signi"cantly falls in all six countries. The magnitude and persistence of the interest rate
increase and the money supply decline di!ers among countries, but in all of them
the e!ects are statistically signi"cant on impact and over the medium run. The
increase in interest rates tends to be smaller in absolute value and less persistent
than the fall in the money supply but this is not surprising. Since, as we will see
below, the monetary contraction leads to a de#ation in the price level, it follows
that the interest rate increase is likely to be small and not very persistent.
 The scale shows percentage deviations from an underlying growth path.
 They were generated from 3000 draws by Monte Carlo Integration following Sims and Zha
(1994); this is a Bayesian method which employs a Gaussian approximation to the posterior of G .


574

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

Fig. 2. Impulse responses to monetary policy shocks.

Consider now the impulse response of the other variables to the contractionary monetary shock. In all countries the price level declines smoothly and
signi"cantly at least over some horizons. In Germany, the U.K., Italy, and
Canada, the fall in the price level is persistent over the full 48 months horizon
and this decline is statistically signi"cant over the full horizon. In Japan, the
price level falls persistently and signi"cantly for about 24 months. Later, the
price level tends to rise above its initial baseline, but this latter e!ect is not
statistically signi"cant. In France, the price level tends to increase in the "rst few
months following the monetary contraction but the e!ect is not statistically
signi"cant. After about six months the price level starts to fall persistently for
over three years. Given the wide con"dence interval bands, however, this e!ect is
not statistically signi"cant. The overall e!ects of the monetary contraction on
the price level are very satisfactory. There is no evidence of a price puzzle in any
country and, actually, there is a strong, persistent, and signi"cant fall in prices in
most countries.
Consider next the e!ects on the level of output. In all countries the output falls
over some horizon following the monetary contraction. With the exception of
Italy, in all countries this output contraction is statistically signi"cant over some
relevant time horizon. In Germany, Japan and the U.K. the output contraction
starts right after the monetary contraction, which is statistically signi"cant for at

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

575

least 18 months and, consistently with the transitory e!ects of a monetary

contraction, the output level shows evidence of a mean reversion to its pre-shock
level. In France and Canada, output falls signi"cantly after a brief period in
which it increases. It should, however, be observed that the initial increase is not
statistically signi"cant. Therefore, for a few months, the monetary contraction
has no signi"cant e!ect on output; but, with a short lag, the fall in output begins
to appear in the impulse response and becomes statistically signi"cant. A mean
reversion to its initial level is also very clear in the response of output over
a longer horizon in these two countries. Finally, in the case of Italy, the response
of the level of economic activity is qualitatively similar to that in the other
countries, an initial persistent fall in output followed by a mean-reverting return
to the initial level. However, the con"dence intervals are large enough that the
initial contraction is not statistically signi"cant. The overall response of output
to the monetary contraction is reasonable in all countries. In all cases, there is
a fall in economic activity followed by a return to the initial level; and in most
cases these e!ects are statistically signi"cant.
As an early summary of these initial results we cannot be sure, from the
evidence of estimated impulse responses alone, whether the identi"ed shocks
represent monetary policy shocks. However, we "rst presented a set of sensible
identifying assumptions about money supply behavior and the structural links
in the economy; next, the impulse response of the model based on these
identifying assumptions turned out to be consistent with a broad set of analytical models about the e!ects of monetary policy shocks.

 In our monetary policy reaction function, we did not include the contemporaneous FFR. We
examined its role and importance by estimating the system including the U.S. interest rate in the
monetary policy equation. In the half of countries, we found very unreasonable dynamic responses
of the macro variables. We guess that the inclusion of the U.S. interest rate makes it di$cult to
separately identify the money supply and the exchange rate equations. In the other half of countries,
the results are not much di!erent from those of the system excluding the U.S. interest rate. So,
inclusion of the interest rate produces either unreasonable dynamic responses or similar qualitative
results. These results, and our discussion in Section 2.2, suggest that our exclusion restriction on
current FFR seems reasonable.
 We examined the robustness of our results to changes in the identifying restrictions of the
model. We experimented with alternative sensible identifying restrictions regarding the monetary
policy reaction function, the money demand equation, the price-output block and the U.S. Federal
Funds equation. Some changes in identifying assumptions generate impulse responses (such as the
price puzzle) that are not consistent with expected e!ects the e!ects of monetary policy. Some
identifying restrictions provide impulse responses that may be more consistent with theoretical
predictions. The g "0 restriction in the French and Italian system have an economic justi"cation

and lead to impulses responses which are slightly more consistent with theoretical predictions. They
do not, however, a!ect the qualitative nature of our results in general. For example, the case of
including the exchange rate in the Fed Funds equation for Germany and Japan; such restrictions are
justi"ed (as discussed below) by the large country interactions and the resulting impulse responses
for the exchange rate are stronger, but qualitatively similar.

576

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

3.3. Ewects of monetary policy shocks on the exchange rate

We now consider the e!ects of the monetary policy shocks on the level of the
exchange rate. In all six cases, the impact e!ect of a monetary contraction (an
increase of the domestic interest rate) is an appreciation of the domestic exchange rate relative to the U.S. dollar; such impact appreciation is statistically
signi"cant in all cases.
In the cases of Germany and Japan, the U.S. Federal Funds Rate tends to
marginally increase when there is a positive interest rate shock in these two
countries. The result is not surprising for two reasons: "rst, since these are the
two economies in the group that are large and potentially able to a!ect world
interest rates; second, the U.S. Fed may respond to a German/Japan monetary
tightening that leads to a U.S. $ depreciation with a Federal Funds rate increase.
In both interpretations, the U.S. Federal Funds rate responds endogenously to
interest rate shocks in Japan and Germany (and to the exchange rate as well). To
consider these large country feedback e!ects, we estimated for Germany and
Japan a modi"ed variant of the basic model where we allow for a contemporaneous e!ect of the $/Yen (Mark) exchange rate on the U.S. Federal Funds rate.
In terms of the scheme in Eq. (6), this means that, in the modi"ed system, we
estimate the contemporaneous coe$cient g instead of imposing a zero restric
tion on it. The impulse responses for the modi"ed system suggest that, once we
control for potential contemporaneous e!ects of the exchange rate on the U.S.
Federal Funds rate, the e!ects of a German (Japanese) monetary contraction on
the Mark (Yen) versus U.S. $ exchange rate are stronger than before (see the
working paper version of the paper, Kim and Roubini, 1997, for details).
For the ERM countries like Italy and France (but not the U.K. who was in the
ERM only in the 1990}1992 period), it is possible that their exchange rate
relative to the U.S. dollar might be partly a!ected by the constraints imposed on
these two countries by their participation to the ERM. For example, if Germany
was the leader of the EMS, a German monetary contraction leads to French and
Italian monetary contraction: as a result, German policies a!ect the exchange
rate between France (or Italy) and the U.S. That is, our identi"ed monetary
policy shocks of France and Italy may include endogenous reactions to the
German monetary policy. To address this issue, we examined the cross-correlation of our identi"ed monetary policy shocks. We found almost zero correlations, which suggests that our identi"ed monetary policy shocks are exogenous
to other countries' monetary policy shocks. Of course, a more formal analysis
may include the German monetary variables in the monetary reaction function
for the France and Italy. For an intra-ERM analysis using a similar identi"cation scheme, see Kim (1998a,b): he "nds that qualitatively similar responses of
exchange rate to monetary policy shocks are found within the ERM countries.
Consider next, the dynamic behavior of the exchange rate over time following
a monetary contraction. Under the uncovered interest parity condition (UIPC),

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

577

a positive innovation in domestic interest rates relative to foreign interest rates

should be associated over time with a persistent depreciation of the domestic
currency after the impact appreciation. However, the empirical results in
Eichenbaum and Evans (1995) and Grilli and Roubini (1995) suggest that
a positive interest di!erential in favor of domestic assets is associated with
a persistent appreciation of the domestic currency. Usually, this persistent
appreciation (&delayed overshooting') continues for periods up to two years after
the initial monetary policy shock.
Now compare the previous results with those obtained in Figs. 1 and 2. As
seen in Figs. 1 and 2, the initial impact appreciation of the currency following the
monetary shock is not followed by the long and persistent appreciation found in
previous studies. In almost all cases, after the initial impact appreciation, the
exchange rate starts to depreciate quite quickly. This depreciation does not
occur right after the impact appreciation: it usually takes a few months. Note
that, while the exchange rate does not depreciate right away after the impact
appreciation, the con"dence intervals suggest that there is no clear persistent
appreciation either. In fact, in most countries, the impulse response of the
exchange rate in the "rst few months is statistically not distinguishable from the
impact e!ect; i.e. there is no statistically signi"cant persistent appreciation
that would be inconsistent with the UIPC. Moreover, we do not observe the
persistent appreciation (delayed overshooting) for periods of over two years
found in previous work. Instead, quite consistently with the UIPC, a persistent
depreciation follows quite soon after the impact change in interest rates. While
the dynamic pattern of the exchange rate after the impact appreciation does not
exactly follow the one implied by the UIPC, the shape of the response is much
closer to that suggested by the UIPC than the impulse responses found in
previous work: i.e. a monetary contraction is associated with an initial impact
appreciation followed by a subsequent persistent and signi"cant depreciation.
To examine, more formally, whether the uncovered interest parity condition is
violated, as in Eichenbaum and Evans (1995), we de"ne the excess return (t as
R
the ex-post di!erence in the return between investing in one-period U.S. assets
and one period foreign assets, i.e.:
t "R31!R #(E !E ).
(7)
R
R
R
R>
R
If the UIPC holds and expectations are rational, the conditional expectation
of the excess return should be zero. On the basis of our estimated VAR's, we
calculate the impulse response function of the conditional expectation of (t to
R
a monetary policy shock. Then, we examine whether (given the UIPC) such
conditional expectation is zero. The last row of Figs. 1 and 2 report the point

 These results are also consistent with those found in the forward discount literature (see Froot
and Thaler, 1990).

578

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

estimates and one-standard error bands of the impulse response function for the
conditional expectation of (t (denoted by FD in the last row of the "gures) that
R
are implied by the impulse responses in rows 1, 6 and 7. The results can be
better understood with a comparison to those in Eichenbaum and Evans (1995):
they found evidence of persistent and signi"cant excess returns for prolonged
periods of time after monetary shocks that was consistent with the evidence of
a delayed overshooting. In Figs. 1 and 2 instead we do not "nd systematic
evidence of signi"cant excess returns. The excess returns are highly noisy over
horizons of 12 months and usually statistically insigni"cant; they are statistically
di!erent from zero at some horizons (12}24 months) in the cases of Germany
and Japan; even in these cases their absolute values are small (a few basis points).
We did some further analysis to understand which aspects of our models
contribute to resolve the previous puzzles. First, the use of a non-recursive
system seems very important in all countries; when we estimate the recursive
system, we "nd several puzzles in all countries. Second, we examined whether
the inclusion of the oil price is essential. In this regard, "rst we examined the
forecast error decomposition of interest rate and CPI due to oil price shocks.
Except for the U.K. and Canada (oil exporting countries), the oil price explains
40}54% of price #uctuations and 28}32% of interest rate #uctuations at the
two-year horizon in each country. This suggests that the inclusion of the oil
price helps the resolution of the price puzzle and the problem of policy endogeneity. We also constructed a 6-variable non-recursive system where the oil
price is dropped but other structure is the same. As expected from the variance
decomposition results, we do not "nd much di!erence of impulse responses in
the U.K. and Canada. However, in Italy, the impulse responses from 6-variable
system showed the price puzzle and exchange rate puzzle. In France, the impulse
responses are di$cult to be thought as those from monetary policy shocks. In
Germany and Japan, though we do not "nd any clear puzzles, the impulse
responses are di!erent in their size. In this case, the impulse responses from
7-variable VAR seem more reliable considering the substantial contribution of
oil price shocks to interest rate and price level. We also examined the impulse
responses to oil price shocks. As expected, in response to oil price shocks, we
"nd a prolonged interest rate increase and price increases in most countries,
which is consistent with monetary contraction after an in#ationary oil price
shock. In conclusion, in most countries, the inclusion of the oil price seems
important in identifying monetary policy shocks.

 The impulse responses represent monthly excess returns at an annualized rate.

 The contribution of oil price shocks in a recursive system where the oil price is contemporaneously exogenous to all variables is similar to the contribution in our non-recursive system.
 Consistent with our evidence on variance decomposition, the tendency is very small in the U.K.
and Canada.

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

579

We also examined the robustness of our results to the use of di!erent

monetary aggregates (M0, M1, and M2). The quantitative results change a bit,
as in Sims and Zha (1995) and Kim (1999), but the qualitative results are quite
robust; we observe neither the exchange rate puzzle nor a signi"cant forward
discount bias puzzle. Other responses are also very reasonable, except for few
cases where we could not "nd a signi"cant drop in the money supply (especially
when M2 is used) or the price level. So, our result that the chosen identi"cation
scheme can resolve the puzzles, especially the responses of exchange rate, is
robust to the use of di!erent monetary aggregates.
3.4. Sources of output and nominal exchange rate yuctuations
We report the next results regarding the sources of output #uctuations and
nominal exchange rate #uctuations. In Table 3, we report the forecast error
variance decomposition of industrial production, and the forecast error variance
of nominal exchange rate due to monetary policy shocks. At the top, the
horizons at which forecast errors were calculated are denoted. The numbers in
the parentheses are standard errors. First, in most countries, the monetary
policy shocks' contribution in explaining output #uctuations is about 10% at
the peak, and monetary policy shocks are not the dominant sources of output
#uctuations. This result supports the "nding of Kim (1999): monetary policy
shocks are not major sources of output #uctuations in G-7 countries. Second, in
most countries, foreign shocks explain substantial part of output #uctuations,
especially in the long run. The foreign block (FFR and OPW) explains
18.7}42.2% of output #uctuations at the peak. Considering that a substantial
part of the E(/$) shocks is originating from foreign sector, we can infer that more
than one-third of output #uctuations are due to shocks originating from the rest
of the world or foreign countries. The oil price shocks explain substantial part of
output #uctuations in Germany, Japan and U.K. In Germany, at a 48-month
horizon, they explain 27.3% of output #uctuations. Also, in Japan and the U.K.,
they explain about 20% of output #uctuations at a 48-month horizon. On the
other hand, in Canada, the U.S. Federal Funds rate shocks explain 34.4% of
output #uctuations at 24-month horizon. Third, in most countries, monetary
policy shocks explain a very large proportion of exchange rate #uctuations in
the short-run. In Italy and Canada, over half of nominal exchange rate #uctuations are due to monetary policy shocks at 6-month horizon. In Japan and the
U.K., substantial parts of exchange rate #uctuations are due to monetary policy
shocks at short-horizons while the contribution is smaller in Germany and
France.

 Standard errors in variance decomposition were generated by the same methods that we used
to calculate standard error bands for impulse responses.

580

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

Table 3
Forecast error variance decomposition
(1) Forecast error variance of output due to monetary policy (MS), oil price (OPW), Federal Funds
Rate (FFR), and Exchange Rate (E(/$)) shocks

Germany

Japan

U.K.

France

Italy

Canada

MS
OPW
FFR
E(/$)
MS
OPW
FFR
E(/$)
MS
OPW
FFR
E(/$)
MS
OPW
FFR
E(/$)
MS
OPW
FFR
E(/$)
MS
OPW
FFR
E(/$)

12 months

24 months

48 months

9.6
3.2
8.3
3.6
6.4
3.0
9.6
3.4
9.9
10.6
3.6
3.7
5.2
4.5
3.7
4.0
3.8
6.5
5.7
15.1
3.1
4.5
19.7
2.9

14.0
8.0
11.2
7.8
10.4
10.7
9.7
8.8
9.6
17.0
7.7
5.3
8.4
6.0
7.4
11.5
6.5
6.9
6.6
20.1
9.1
4.4
34.4
3.9

10.0
27.3
14.8
8.2
10.2
21.8
8.3
12.3
8.1
19.6
8.3
12.4
9.2
15.3
8.9
13.4
7.3
9.5
9.2
18.3
10.7
5.0
31.6
7.6

(8.2)
(2.4)
(5.2)
(2.9)
(5.5)
(2.8)
(6.2)
(3.6)
(6.7)
(7.0)
(2.9)
(3.7)
(3.7)
(3.6)
(2.9)
(2.9)
(3.5)
(4.9)
(4.2)
(7.8)
(2.3)
(4.1)
(8.9)
(2.8)

(11.1)
(5.2)
(5.6)
(6.3)
(7.5)
(7.0)
(6.6)
(7.1)
(6.3)
(9.6)
(5.8)
(4.7)
(6.4)
(3.8)
(6.7)
(7.5)
(6.0)
(4.9)
(5.2)
(9.9)
(6.3)
(3.8)
(11.2)
(3.5)

(8.6)
(10.6)
(8.3)
(5.6)
(6.5)
(11.6)
(5.7)
(8.7)
(5.0)
(10.1)
(6.4)
(7.8)
(6.9)
(9.1)
(7.4)
(8.6)
(6.3)
(6.4)
(7.3)
(9.3)
(7.1)
(4.0)
(10.8)
(6.0)

(2) Forecast error variance of nominal exchange rate due to monetary policy shocks

Germany
Japan
U.K.
France
Italy
Canada

6 months

12 months

24 months

48 months

4.4
26.0
34.2
8.2
58.3
61.2

4.6
22.2
29.1
7.5
40.9
58.0

4.5
18.0
21.0
10.7
25.8
49.7

4.6
17.0
16.6
10.2
15.2
45.3

(5.5)
(23.7)
(19.7)
(9.1)
(13.9)
(10.4)

(5.9)
(20.4)
(17.0)
(7.3)
(12.4)
(11.1)

(5.0)
(16.1)
(11.8)
(7.4)
(9.1)
(12.4)

(4.6)
(12.9)
(9.0)
(7.5)
(6.8)
(13.2)

3.5. Ewects on the real exchange rate

Next, we consider the e!ects of the monetary shocks on the real exchange rate.
To do so, we rerun the basic system by substituting the nominal exchange rate
with the real exchange rate. Formally, we could have added the real exchange
rate to the original system rather than substitute the nominal with the real rate;

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

581

we substitute the nominal with the real exchange rate to save degrees of freedom.
Note that both overshooting and liquidity models imply that a monetary
contraction (higher interest rates) will lead to a transitory fall in output and
a persistent nominal and real appreciation of the exchange rate. The real
appreciation will, however, be transitory and the real rate will return in the long
run to its pre-shock level after all prices and wages have adjusted.
The impulse responses to a monetary shock in the G-6 countries in the system
with the real exchange rate are presented in Fig. 3. A comparison of Figs. 1}3
shows the nominal appreciation of the exchange rate following a monetary
tightening is associated with a (statistically signi"cant) real appreciation of
a similar magnitude: since prices of goods adjust slowly in the short-run,
a nominal appreciation leads to a real appreciation. However, Fig. 3 also shows
that over time, as prices adjust, the real appreciation tends to reverse itself in
most countries and the real exchange rate returns to its pre-shock value. This
mean-reverting behavior of the real exchange rate is consistent with the longterm implication of a monetary shock in overshooting and liquidity models.
3.6. Ewects of U.S. interest rate shocks on the non-U.S. G-7 countries
Finally, we considered the e!ects of U.S. interest rate shocks on the economies
of the other G-7 countries. We took the basic system estimated above and

Fig. 3. Impulse responses to monetary policy shocks.

582

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

Fig. 4. Impulse responses to FFR shocks.

considered the response of the macro variables of the non-U.S. G-7 countries to
a positive U.S. Federal Funds rate shock. Note that the U.S. Federal Funds rate
shocks may re#ect not only the U.S. monetary policy shocks, but also other
structural shocks such as the in#ationary shocks which are not re#ected in the
world oil price movements, since in our system the Federal Funds rate is
contemporaneously exogenous to all other variables except for the world oil
price.
The impulse responses are presented in Fig. 4. As the U.S. Federal Funds rate
increases, we observe a similar increase in short-term interest rates in the other
countries. This could be the result of two e!ects: "rst, since the U.S. is a large
country, higher rates in the U.S. tend to increase interest rates in other countries;
second, the monetary authorities of the non-U.S. G-7 countries may respond to
an increase in U.S. interest rates by increasing their own interest rates to avoid
the in#ationary e!ect of the devaluation of their currencies. The resulting
increase in interest rate is associated with a fall in the money supply in the

 See Kim (1998b) for the evidence on the international transmission of the U.S. monetary policy
shocks.

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

583

non-U.S. G-7 countries (with two exceptions in the case of Japan and France).
The currencies of all countries relative to the U.S. dollar depreciate on impact,
but the depreciation is short-lived in most cases as the exchange rate shows
evidence of overshooting. The depreciation of the currency is associated with an
in#ationary burst, as in all countries except for the U.K., domestic prices tend to
increase signi"cantly after the domestic depreciation. The output response is
mixed, as two forces counter each other. On one side, as the nominal and real
exchange rate depreciates, aggregate demand is stimulated and output should
increase, while on the other side, the higher interest rate dampens aggregate
demand and tends to reduce output. In small countries like Canada, where the
interest rate reacts strongly to the U.S. rate increase, the second e!ect dominates
(while the "rst one is small, since the Canadian dollar does not depreciate much
and the Canadian interest rate increase in tandem with the U.S. ones); therefore,
output falls signi"cantly and then tends to return to its pre-shock value. In large
countries such as Japan and Germany, where the domestic interest rate increase
following the U.S. shock is smaller, the exchange rate depreciates by more
following the Fed Funds shock and, consequently, the output response is
positive and signi"cant even if short-lived. Finally, the last row on &excess
returns', again does not show evidence of signi"cant systematic excess returns
following the U.S. interest rate shock.

4. Concluding remarks
In this paper we developed an open economy structural VAR model to
address a number of empirical anomalies about the e!ects of monetary policy in
open economies. The identi"cation scheme used in the paper appears to be
successful in identifying monetary policy shocks and solving the puzzles and
anomalies regarding the e!ects of monetary policy shocks. The &liquidity puzzle'
is addressed and there is no evidence of a &price puzzle': the price level falls
following a contractionary monetary policy shock. Moreover, there is no evidence of an &exchange rate puzzle': the impact response of the exchange rate to
a monetary contraction is the appreciation predicted by theory. Finally, there is
little evidence of a &forward discount bias puzzle' and delayed overshooting.
Our identi"cation scheme generates &sensible' monetary policy shocks in the
sense that the dynamic response functions are not inconsistent with widely
shared priors about the qualitative impacts of a monetary policy shock on
di!erent variables. The absence of a liquidity and price puzzle is indirect

 This ambiguity of the spillover e!ect of foreign monetary shock is a well-known feature of the
Mundell}Fleming model and emerges in similar ways in overshooting and liquidity models (see
Grilli and Roubini, 1991).

584

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

evidence that the identi"cation scheme is not grossly at odds with sensible
economic priors. The transitory e!ects of monetary policy on output suggest
that the output e!ects of monetary policy are statistically signi"cant, but of
small empirical magnitude. Given the presence of an &exchange rate puzzle' in
previous studies, the absence of such a puzzle in our results is also consistent
with the view that the identi"cation scheme is able to distinguish the components of interest rate shocks due to Fisherian e!ects from those due to true
monetary tightening. The latter leads to the expected impact appreciation of the
nominal exchange rate suggested both by overshooting and liquidity models of
the exchange rate. In open economy models, qualitative and quantitative inferences about the e!ects of monetary policy are partially di!erent across
identi"cation methods; they depend on whether you use a non-recursive identi"cation scheme or a recursive one (as in Sims, 1992; Eichenbaum and Evans,
1995; Grilli and Roubini, 1995). Our structural VAR approach contributes to
solving the price puzzle and exchange rate puzzles for non-U.S. industrial
countries and provides some initial evidence that delayed overshooting (and
deviations from UIPC) may not systematically occur.
There are several issues that have not been addressed in the present analysis.
First, it would be interesting to include measures of "scal policy to study the
e!ects of such shocks on the nominal and real exchange rate. Second, it would be
interesting to consider "xed exchange rate periods, such as the Bretton Woods
period or the inter-EMS exchange rates in the post-1979 period; the presence of
signi"cant capital controls in the above two cases of "xed rate regimes suggests
that it would be interesting to study the e!ectiveness of monetary policy in those
regimes. Third, one could analyze whether the real e!ects of monetary shocks
result from the aggregate demand e!ects stressed by overshooting models with
sluggish price/wage adjustment or from the supply side e!ects stressed by
liquidity models with sluggish adjustment of asset demand decisions.
References
Beaudry, P., Devereux, M.B., 1995. Monopolistic competition, price setting and the e!ects of real
and monetary shocks. Working paper, Boston University, MA.
Bernanke, B., 1986. Alternative explanations of the money-income correlation. In: Brunner, K.,
Metzler, A.H. (Eds.), Real Business Cycles, Real Exchange Rates, and Actual Policies. CarnegieRochester Series on Public Policy 25. North-Holland, Amsterdam, pp. 49}99.
Blanchard, O.J., Watson, M.W., 1986. Are business cycles all alike?. In: Gordon, R. (Ed.), The
American Business Cycle: Continuity and Change. University of Chicago Press, Chicago, IL, pp.
123}156.

 See Kim (1998a) for a "rst study.

 See Grilli and Roubini (1991, 1992, 1996) and Christiano and Eichenbaum (1992b, 1995). See
Christiano et al. (1996, 1997) for some initial evidence on this issue.

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

585

Chari, V.V., Christiano, L.J., Eichenbaum, M., 1995. Inside money, outside money and short term
interest rates. Journal of Money, Credit and Banking 27, 1354}1385.
Christiano, L.J., Eichenbaum, M., 1992a. Identi"cation and the liquidity e!ects of a monetary policy
shock. In: Cuikerman, A., Hercowitz, Z., Leiderman, L. (Eds.), Political Economy, Growth and
Business Cycles. MIT Press, Cambridge, MA, pp. 335}370.
Christiano, L.J., Eichenbaum, M., 1992b. Liquidity e!ects and the monetary transmission mechanism. American Economic Rev. 82, 346}353.
Christiano, L.J., Eichenbaum, M., 1995. Liquidity e!ects, monetary policy and the business cycle.
Journal of Money, Credit, and Banking 27, 1113}1116.
Christiano, L., Eichenbaum, M., Evans, C., 1996. The e!ects of monetary policy shocks: evidence
from the #ow of funds. Review of Economics and Statistics 78, 16}34.
Christiano, L., Eichenbaum, M., Evans, C., 1997. Sticky price and limited participation models of
money: a comparison. European Economic Review 41, 1201}1249.
Clarida, R., Gertler, M., 1997. How the Bundesbank conducts monetary policy. In: Romer, C.,
Romer, D. (Eds.), Reducing In#ation. University of Chicago Press, Chicago, IL, pp. 363}406.
Cushman, D.O., Zha, T., 1997. Identifying monetary policy in a small open economy under #exible
exchange rates. Journal of Monetary Economics 39, 433}448.
Dornbusch, R., 1976. Expectations and exchange rates dynamics. Journal of Political Economy 84,
1161}1176.
Eichenbaum, M., 1992. Comments on &Interpreting the macroeconomic time series facts: the e!ects
of monetary policy'. European Economic Review 36, 1001}1011.
Eichenbaum, M., Evans, C., 1995. Some empirical evidence on the e!ects of monetary policy shocks
on exchange rates. Quarterly Journal of Economics 110, 975}1010.
Froot, K., Thaler, R., 1990. Anomalies: foreign exchange. Journal of Economic Perspectives 4, 179}192.
Goldberg, P.K., Knetter, M.M., 1996. Goods prices and exchange rates: what have we learned?
National Bureau of Economic Research Working Paper No. 5862.
Gordon, D.B., Leeper, E.M., 1994. The dynamic impacts of monetary policy: an exercise in tentative
identi"cation. Journal of Political Economy 102, 228}247.
Gourinchas, P.-O., Tornell, A., 1995. Exchange rate dynamics and learning. Working paper MIT,
MA.
Grilli, V., Roubini, N., 1991. Financial intermediation and monetary policies in the world economy.
National Bureau of Economic Research Technical Working Paper No. 104.
Grilli, V., Roubini, N., 1992. Liquidity and exchange rates. Journal of International Economics 32,
339}352.
Grilli, V., Roubini, N., 1993. Liquidity, capital controls, and exchange rates. Journal of International
Money and Finance 12, 139}153.
Grilli, V., Roubini, N., 1995. Liquidity and exchange rates: puzzling evidence from the G-7 countries.
Working paper, Yale University, CT.
Grilli, V., Roubini, N., 1996. Liquidity and exchange rates in open economies: theory and empirical
evidence. European Economic Review 40, 847}859.
Kim, S., 1998a. Exchange rate stabilization in the ERM: identifying European monetary policy
reactions. Working paper, University of Illinois, IL.
Kim, S., 1998b. International transmission of the U.S. monetary policy shocks: evidence from VAR's.
Working paper, University of Illinois, IL.
Kim, S., 1999. Does monetary policy shocks matter in the G-7 countries? Using common identifying
assumptions about monetary policy across countries. Journal of International Economics 47,
871}893.
Kim, S., Roubini, N., 1997. Liquidity and exchange rates in the G-7 countries: evidence from
identi"ed VAR's. Working paper, New York University, NY.
Leeper, E.M., Gordon, D.B., 1991. In search of the liquidity e!ect. Journal of Monetary Economics
29, 341}369.

586

S. Kim, N. Roubini / Journal of Monetary Economics 45 (2000) 561}586

Reichenstein, W., 1987. The impact of money on short term interest rates. Economic Inquiry 25,
67}82.
Schlagenhauf, D.E., Wrase, J.M., 1995. Liquidity and real activity in a simple open economy model.
Journal of Monetary Economics 35, 431}462.
Sims, C.A., 1980. Macroeconomics and reality. Econometrica 48, 1}48.
Sims, C.A., 1986. Are forecasting models usable for policy analysis? Federal Reserve Bank of
Minneapolis Quarterly Review 10, 2}16.
Sims, C.A., 1988. Bayesian skepticism on unit root econometrics. Journal of Economic Dynamics
and Control 12, 463}474.
Sims, C.A., 1992. Interpreting the macroeconomic time series facts: The e!ects of monetary policy.
European Economic Review 36, 975}1000.
Sims, C.A., Uhlig, H., 1991. Understanding unit rooters: a helicopter tour. Econometrica 59,
1591}1599.
Sims, C.A., Zha, T., 1994. Error bands for impulse responses. Working paper, Yale University, CT.
Sims, C.A., Zha, T., 1995. Does monetary policy generate recessions?: Using less aggregate price data
to identify monetary policy. Working paper, Yale University, CT.
Strongin, S., 1995. The identi"cation of monetary policy disturbances: explaining the liquidity
puzzle. Journal of Monetary Economics 35, 463}497.