Real and Nominal Shocks to Exchange Rates : Does the Regime Matter?

In this paper we investigate the source of Irish real and nominal exchange rate movements during the Exchange Rate Mechanism period. A restricted vector autoregression is employed to decompose Irish pound exchange rate movements into changes due to real and nominal factors, for three bilateral exchange rates - sterling-Irish pound, mark-Irish pound and dollar-Irish pound. The pattern of nominal exchange rate overshooting in response to nominal shocks and the relative importance of nominal shocks as drivers of nominal exchange rates differ between the flexible regime (sterling-Irish pound and dollar-Irish pound) and the target zone arrangement (mark-Irish pound). In contrast real shocks predominantly explain variations in real exchange rates and are independent of the exchange rate regime