Noise trading and delayed exchange rate overshooting

A number of empirical studies have reported that exchange rates show a delayed overshooting in response to a monetary policy shock. This finding is puzzling. Economic theory suggests that overshooting should occur immediately after the shock (i.e., with no delay). This paper uses a 'new open economy macroeconomics' model with pricing-to-market behavior to analyze whether noise trading in the foreign exchange market helps to explain the delayed overshooting puzzle. To this end, the implications of noise trading for the effects of a monetary policy shock on the nominal and on the real exchange rate are analyzed.