Monetary Policy and Exchange Rate in a Structural VAR for a Small Open Economy

The impact of the monetary policy on the exchange rate and other macroeconomic variables is analyzed for the case of Colombia, a small open economy. Block exogeneity restrictions are imposed in a novel way in a structural VAR, including local and foreign variables. The results are robust to various specifications and show a partial solution of the forward discount bias puzzle, i.e. partial evidence of the uncovered interest parity (UIP). This was not the case in previous research with the same methodology for Colombia. It also finds strong evidence in favor of the central bank leaning against the wind and partial evidence of no pass through from exchange rate to inflation.