Using Long-Run Restrictions to Investigate the Sources of Exchange Rate Fluctuations

This paper makes use of long-run restrictions to identify macroeconomic shocks and evaluate their relative importance for exchange rate fluctuations. Unlike previous studies that employ a similar approach, I consider a large eight variable vector autoregressive system that includes short term interest rates rather than money stocks in order to help identify monetary policy shocks. Results for the U.S. and the U.K. show that monetary policy shocks and other macroeconomic shocks behave according to theory. However, monetary shocks account for only a small fraction of the variance of the real exchange rate. Instead, “taste shocks” that can be associated with the degree of trade openness, terms of trade, and current account appear to be the key factor driving the U.S.-U.K. real exchange rate. Results for other countries under consideration (Canada, Germany, and Japan) are similar.