Delayed Overshooting: Is It an 80s Puzzle?

The delayed overshooting puzzle refers to a well-documented empirical tendency by which a domestic monetary contraction induces a protracted phase of appreciation of the domestic currency prior to a gradual depreciation, against most standard economic models and assumptions that would predict maximal appreciation on impact.

In a recent paper, Professor Carlos Velasco and S.-H. Kim (Yonsei University) and S. Moon (Chonbuk National University) have reinvestigated this puzzle by examining the conditional response of exchange rates for 14 US trading partners over the 1976 –2007 period. To find recognizable shifts in the monetary policy regime they compare the behavior of exchange rates over three different periods: the entire sample period, the Volcker era, and the post-Volcker era. The Federal Reserve under Paul Volcker’s chairmanship (1979-1987) conducted a tight monetary policy to combat the 1970s inflation. This disinflation plan finally had important success and impact on US economy after some initial serious credibility concerns.

The first empirical finding of the paper is that the delayed overshooting in response to US monetary policy shocks appears to prevail in the entire sample period and that a single particular subsample, the Volcker era, is primarily responsible for that conclusion by contaminating the entire sample period. This effect has mislead previous empirical studies to prematurely conclude the failure of the overshooting hypothesis, despite exchange rates overshoot immediately on impact of US monetary policy shocks during the post- Volcker era.

The authors argue that one explanation for these results can be found in the close connection between the overshooting hypothesis and its key assumption, uncovered interest parity (UIP). In parallel with the behavior of exchange rates, UIP, both conditional and unconditional, fails during the Volcker era but tends to hold during the post-Volcker era. Further, by analyzing the different periods separately it is found that the impact of the monetary policy regime over exchange rate movements is much more substantial than when failing to identify this particular period of the US monetary policy. Connecting all these results, they conclude that exchange rate movements and UIP are as cohesively related in data as they are in theory.

Finally, the imperfect credibility of the Volcker Fed’s disinflation policy in the early 1980s is regarded as a primary reason for the violations of both the overshooting hypothesis and UIP. In this moment, a perceived possibility of a monetary policy U-turn may have triggered the persistent appreciation of the US dollar between 1980 and 1985, explaining why that the Volcker era is so different and influential relative to other periods. To the extent that credibility matters in economic dynamics, this lesson can also advance the study of policy in general.

The paper is now published in the October 2017 issue of the Journal of Political Economy.