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

Abstract

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 ratesösterling^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 di¡er between the £exible 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.