DP13597 Exchange Rate Undershooting: Evidence and Theory
We reconsider the delayed overshooting puzzle through the lens of a New Keynesian model with information rigidities. In the model, market participants do not directly observe the natural rate of interest and learn from unanticipated shifts in monetary policy about the state of the economy. We estimate the model and find that it can account for the joint responses of spot and forward exchange rates, excess returns, and macroeconomic indicators to monetary policy shocks. Our results suggest that information rigidities are important for understanding exchange rate dynamics.