Monetary policy and the exchange rate: Evaluation of VAR models

► The ability of VAR models to identify the transmission mechanism in an experiment. ► Data simulated from a small open economy DSGE model estimated for Australia. ► Sign restricted VARs estimate the impulse responses much better than recursive VARs. ► Sign-restricted VARs able to overcome puzzles related to the real exchange rate. ► Central tendency measures of sign-restricted VARs can be misleading.