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We estimate an empirical model of exchange rates with transitory and permanent monetary shocks. Using monthly post-Bretton-Woods data from the United States, the United Kingdom, and Japan, we report four main findings: First, there is no exchange rate overshooting in response to either temporary or permanent monetary shocks. Second, a transitory increase in the nominal interest rate causes appreciation, whereas a permanent increase in the interest rate causes short-run depreciation. Third, transitory increases in the interest rate cause short-run deviations from uncovered interest-rate parity in favor of domestic assets, whereas permanent increases cause deviations against domestic assets. Fourth, permanent monetary shocks explain the majority of short-run movements in nominal exchange rates.

Exchange Rates and Uncovered Interest Diﬀerentials: The Role of Permanent Monetary Shocks