December 2019 issue contents
Identifying Dornbusch's Exchange Rate Overshooting with Structural VECs: Evidence from Mexico

Carlos Capistrán,a Daniel Chiquiar,b and Juan R. Hernándezb


We propose an approach where, by imposing a rich longrun structure to a structural vector error-correction model (SVEC), we find a response of the exchange rate to monetary policy shocks consistent with Dornbusch's exchange rate overshooting hypothesis in data from Mexico. The model accommodates long-run theoretical relationships on macroeconomic variables (a purchasing power parity, an uncovered interest parity, a money demand, and a relationship between domestic and U.S. output). We identify, estimate, and test the long-run relationships using an ARDL methodology. We then impose a recursiveness assumption on the SVEC to identify the response of domestic variables to a monetary policy shock.

JEL Code: C32, C51, E10, E17.

Full article (PDF, 48 pages, 2,274 kb)


a Bank of America Merrill Lynch
b Banco de México