Identifying Dornbusch's Exchange Rate Overshooting with Structural VECs: Evidence from Mexico

We propose an approach where, by imposing a rich long-run structure to a structural vector error-correction model (SVEC), we find a response of the exchange rate to monetary policy shocks consistent with Dornbusch's exchange rate overshooting hypothesis in data from Mexico. The model accommodates long-run theoretical relationships on macroeconomic variables (a purchasing power parity, an uncovered interest parity, a money demand, and a relationship between domestic and U.S. output). We identify, estimate, and test the long-run relationships using an ARDL methodology. We then impose a recursiveness assumption on the SVEC to identify the response of domestic variables to a monetary policy shock.